Our own view is that this is a temporary soft patch: We have fiddled with the US forecast to reflect the recent slippage in the tracking estimate for 2Q GDP (now +2.7%), but continue to show a stronger performance over 2H. On a 4Q/4Q basis, our forecast for GDP growth is now +3.2% in 2011 and +3.0% in 2012. Both figures are little changed from a month ago.
Sustaining the recovery requires job growth: While there weren't too many bright spots in Friday's numbers, there was sufficient upside in wage rates and hours worked to suggest that the income and production sides of the economy will show moderate growth in May. In particular, aggregate weekly payrolls, a proxy for private wages and salaries, rose 0.4%, about as we had anticipated and in line with the recent trend. Also, hours worked in the factory sector jumped 0.5%, pointing to solid growth in manufacturing output during May. However, these types of gyrations in wage rates and hours are probably more statistical than real, and while they buy some time in terms of providing temporary support for income and production, sustaining the economic recovery in the US at this stage of the cycle requires job growth. Any sign that the underlying trend in employment growth is slipping below 150,000 or so would be cause for concern. Thus, the next employment report (due out on July 8) looms large.
From a broader standpoint, we cite four factors that should help to deliver stronger economic growth during 2H11: First, assembly schedules released by the automakers last week point to a near-term spike in vehicle production, suggesting that supply chain disruptions related to the earthquake in Japan are beginning to ebb. Indeed, we estimate that a rise in motor vehicle output aimed at rebuilding depressed inventories will add about 1.5pp to 3Q GDP. This follows on the heels of an estimated 0.8pp subtraction in 2Q, when production was disrupted by earthquake-related parts shortages.
Second, consumer spending should be supported over the next few months by a pullback in prices at the gas pump. Of course, this is just the flip-side of what we saw in 1Q, when nominal consumer spending posted its best gain since 1Q07, but rising prices led to sub-par consumption growth in real terms. The other two contributors to the 2H rebound story are a further acceleration in capital spending tied to the tax benefits that expire at year-end and a significant boost from net exports in 4Q, reflecting the calendar quirk that we have highlighted in the past (see Why Is Our Q4 GDP Estimate So High? December 15, 2010).
We are also announcing a change in the Fed call: Basically, we are pushing out the timing of the expected exit sequencing by 3-6 months relative to what we had previously thought. The logic is that the old path was simply looking too compressed, given the emergence of questions surrounding the sustainability of the recovery. Moreover, even though our inflation story is very much on track (core CPI is expected to hit +1.4%Y in May - up 0.8pp from where it was running as recently as last October), the market doesn't seem to care, and benign inflation expectations give the Fed some breathing room.
Also, the trajectory of rate hikes in the next tightening cycle should be flatter than previously assumed because the FOMC seems committed to asset sales as part of the exit process (see US Economics: Normalizing the Fed's Balance Sheet, May 20, 2011, for a description of viable exit strategy scenarios that might play out in the coming years). Asset sales serve as a partial substitute for rate hikes in achieving the desired magnitude of tightening in financial conditions.
What about QE3? You can never say never, but clearly the bar to a reintroduction of asset purchases by the Fed is quite high. In our view, it would probably take something like the unemployment rate moving close to or through 10% and a core inflation rate dipping back below 1% to make QE3 a realistic possibility. Either of these outcomes seems unlikely - and both together seem like a real stretch. And, even if we get to that point, the Fed may decide that an alternative form of monetary stimulus might be more appropriate than another round of Treasury purchases. QE2 appeared to be effective in terms of easing financial conditions and elevating inflation expectations. But, the beneficial impact on the real economy was muted by a spike in commodity prices that may have been at least partly related to QE2 (even though Bernanke issued a strong challenge to this notion in his recent Atlanta Fed speech). In any case, alternative forms of monetary stimulus, such as yield caps, could have a positive impact on the real economy via a mortgage refinancing and a housing affordability transmission mechanism (see Box 2 in the full report and Bernanke's famous November 2002 speech, Deflation: Making Sure ‘It' Doesn't Happen Here, for more details on how yield caps might work).
Assuming no major additional fiscal tightening: Finally, we should point out that our outlook for the US economy and Fed policy assumes no meaningful fiscal policy changes beyond those already slated to occur when the payroll tax cuts and business expensing provision expire at the end of 2011. In other words, we assume that a debt-ceiling hike will get done with either: i) smoke and mirrors along the lines of unspecified spending cuts over an indeterminate timeframe, with ineffective triggers; or ii) legitimate actions aimed at reining in entitlement spending over the long run but which carry little or no meaningful near-term fiscal policy impact.
For full details, see "Delaying the Fed Exit", The Global Monetary Analyst, June 8, 2011.
1. The Accounting Problem
Japan's first fiscal problem is accurate information. The standard presentation (SP) used at year-end budget time distorts the true picture for two major reasons. First, the definition of government in the SP includes only part of the central government (the so-called ‘general account'). It excludes special accounts, local government and the social security funds. Second, the accounting in the SP is confused. For example, within expenditure, the SP includes payments into the bond redemption fund - a capital transfer that would never be included under normal accounting rules.
So, what does the budget really look like? A comprehensive look for the FY2008 situation is given in the full report. These figures are from the national accounts, and refer to the ‘general government', i.e., the consolidated figures for central government, local government and social insurance. The large transfers among the different levels of government are excluded from the net figures in this presentation.
So, the size of government in FY2008 was JPY196.7 trillion. Tax receipts were JPY139.8 trillion (including social contributions, deducting subsidies as a negative tax). Borrowing was JPY32.5 trillion - and that after net repayments of JPY10.9 trillion in capital transfers (i.e., shedding net assets).
A more illuminating way to look at the fiscal accounts is to break them into functional categories. The operating activities of the government - i.e., the public goods and services, funded by general tax revenues - run a surplus of more than JPY10 trillion. The balance on interest payments is negative, at about JPY5 trillion, or about 1% of GDP. The largest deficit comes in the social benefit balance, at more than JPY46.5 trillion, or 9% of GDP. Thus, the recurring balance is a deficit of JPY41.3 trillion. This deficit was funded by a JPY8.9 trillion net drawdown of assets (i.e., net capital transactions) and JPY32.5 trillion of borrowing.
The time series presentation of this approach to the fiscal accounts is shown in the full report. The figure has a clear conclusion: Until the late 1990s, the social balance remained stable at a deficit of just under 5% of GDP, with minor fluctuations related to the business cycle. Since 1998, when deflation began in earnest, the social balance has been on a continuous path of worsening.
Another problem is data lags. There is a minimum lag of 10 months before the national accounts figures for a given year are available. Hence, a true picture of the fiscal situation is available only more than two years after the fact, and at the tail end of the budget process for the subsequent fiscal year. Such long lags force the debate into reliance on partial figures such as those of the MoF initial budget.
For JGB investors, these observations suggest the first four yardsticks for judging whether the fiscal reform plan is credible. Is there: (a) a clear path to ending deflation? (b) a clear path for the social benefits balance?(c) a clear statement of asset drawdown? and (d) a significant shortening of data lags?
2. The Political Economy of Deficits
Large deficits are a symptom of what fiscal economists call a ‘common pool' problem. Such a problem exists when those enjoying the marginal benefit from an extra dollar spent on a project are not those bearing the marginal cost of funding it. A look at the pattern of spending in social benefits (where the major deficit exists) suggests that there is a common pool problem.
A rough estimate of the age breakdown of transfer benefits from public spending is shown in the full report. We estimate that the elderly account for JPY78 trillion of the total JPY95 trillion of social transfers. In short, the elderly benefit.
Who pays? After all, taxes on production, imports and income fall on the working generation, for the most part, as do social contributions. Only the consumption tax and asset taxes are paid even in part by the elderly. In short, the young pay.
This combination of benefits and burdens suggests that Japan's social choice rules give excess weight to the elderly. Is there evidence? We illustrate that prefectures with older populations require fewer votes to get a seat in either house of the Diet. This fact, together with the tendency of older voters to have higher turnout ratios than young voters, tilts decisions on spending and taxes toward the interests of the elderly.
For JGB investors, the next yardstick for judging fiscal progress is: Will the nation end the bias in the electoral system in favor of the elderly?
3. The Arithmetic of Fiscal Consolidation
Both LDP and DPJ governments have adopted the goal of stabilizing the ratio of government debt to GDP. This is the starting point for the arithmetic of the changes to spending and taxes needed for a successful reform. If one makes the (admittedly heroic) assumption that GDP will not be affected by the fiscal reform, then the potential combinations of spending cuts and tax hikes needed to stabilize the debt ratio are rather simple to calculate.
If the goal is to stabilize the ratio of debt to GDP, then the primary balance of the government (i.e., recurring balance excluding net interest payments) must equal or exceed the term (r-g)*(D/Y), where r is the average borrowing cost, g is the growth rate of nominal GDP, and D/Y is the initial debt level. Using the long-run average for r-g (1.4%) and the FY2008 value of D/Y (198%), the required adjustment is JPY38.2 trillion. The two extreme alternatives are:
a) With no hike of taxes, such an adjustment would imply cutting spending by JPY38.2 trillion, from JPY196.7 trillion to JPY158.5 trillion, a cut of about 19%.
b) With no spending cuts, the consumption tax would have to rise from the current 5.0% to 24.1%, a rise of 19pp.
For JGB investors, this analysis suggests yet another yardstick: Any successful fiscal consolidation plan must start with the rule of thumb above that the consumption tax hike in percentage points plus the spending cut in percentage points must equal 19.
The key word above is ‘start'. This is crucial because the assumption that GDP will be stable in the face of such a major fiscal consolidation is unlikely to be true. Thus, a crucial aspect of fiscal consolidation, quite apart from the mix of spending cuts and tax hikes, is how to maintain economic growth while the fiscal reform proceeds.
4. Fiscal Consolidation and Economic Growth: Mr. Keynes, Meet Mr. Solow
Sustaining any fiscal reform program requires sources of GDP growth that offset the fiscal contraction. Weakening the yen would be the main method for increasing foreign demand. In the longer run, a continuous expansion of Japan's current account surplus will not be allowed by trade partners. Hence, the growth needed to sustain fiscal reform must be domestic.
The supply side is crucial. The working age population will shrink by 0.9% per year over the next decade, while the 65+ population rises by 2.0% per year. Hence, raising the productivity of remaining workers is essential to maintaining living standards. If Japan keeps transfers per person for the elderly at the 2008 level, then productivity growth of 2.8% per year would be necessary until 2020 to keep the transfer share constant.
Thus, fiscal programs are not only about quantity, but also about quality. Unless decisions about the level of benefits for the elderly are consistent with the policies for productivity growth, the fiscal consolidation program will fail.
For JGB investors, these observations suggest another yardstick: Look closely for a pro-growth combination of spending reallocations and tax changes.
5. Scenarios for Fiscal Consolidation and Asset Prices
The impact of fiscal consolidation plans on financial markets depends crucially on the yardsticks mentioned above: (a) Will there be a clear path to ending deflation? (b) Will there be clear paths for the social benefits balance and asset drawdown? (c) Will there be a significant shortening of data lags? (d) Will the bias in the electoral system be in favor of the elderly end? (e) Will the fiscal consolidation plan start with the ΔT + ΔX = 19 rule? (f) Will there be a pro-growth combination of spending reallocations and tax changes?
A schema for how markets may react to the answers to these questions is provided in the full report. The graph shows the dividing line between sustainable and non-sustainable fiscal reform plans, in terms of two key elasticities. Optimists argue that borrowing cost elasticity is less than the tax elasticity multiplied by the ratio of revenue to debt; in this case, higher inflation will reduce the deficits. Pessimists argue that the borrowing cost elasticity is greater than tax elasticity multiplied by the ratio of revenue to debt; in this case, higher inflation will increase the deficits.
We have simulated the impact of different movements of the yield curve on JGB yields and debt services, using the pessimistic assumption that nominal GDP growth does not change.
For the pessimistic case, the average borrowing cost peaks at around 2%. The rise in JGB average issuance duration to six years and five months (as of end-March 2010) means that there is almost no impact from a rise of the yield curve on average funding costs for the fiscal year in question. In addition, redemption of high-coupon bonds from past years has a pay-down effect for debt-servicing costs. (For details, see J-Insight: Rebutting Post-Quake Fiscal Alarm: Keep Concerns in Check but Fiscal Balance Commitment Is Key by Takehiro Sato, Takeshi Yamaguchi and Miho Ohashi, April 26, 2011.)
For the super-pessimistic scenario, we project a 3% rise in 10y interest rates that similarly results in steepening of the 2-10y curve and flattening of the 10-40y curve. In this case, the results are predictably serious. The average funding cost rises above 3% (with no end to deflation), and the debt/GDP ratio spirals out of control.
Even if the fiscal program in Japan starts badly, any rise of bond yields would likely be met with pressure on the Bank of Japan (BoJ) to be more aggressive in funding deficits. We believe that the BoJ would accommodate such requests. After all, in earlier cases, when the government called for more aggressive measures to end deflation, the BoJ has taken steps.
Moreover, the usual arguments against more aggressive BoJ policy are easy to refute. One such argument is that the BoJ has a large balance sheet relative to the economy, compared to other major central banks; this is true, but irrelevant. The reason for the BoJ's large balance sheet is the very high share of banknotes in circulation. This rise of banknotes corresponded perfectly to the worsening of deflation. This rise of banknotes is a perfectly rational response of the population. With deflation, the real return on cash is high and risk-free; of course, cash demand expanded. Ironically, ending deflation may be an effective way to reduce the size of the BoJ balance sheet.
Another such argument is the capital adequacy of the central bank. In fact, the BoJ's capital adequacy is better than that of the Federal Reserve.
The third argument is the BoJ's ‘currency rule', which states that the BoJ's holdings of long-term JGBs should not exceed currency in circulation. The economic logic for this rule is highly questionable. Moreover, the rule was introduced along with the zero-rate policy of 2001, as a way of controlling the expansion of the balance sheet - with no discernable impact. In addition, comparing the BoJ to the Fed shows that the Fed has long passed the point of Treasury holdings exceeding banknotes in circulation, with no loss of credibility. The coup de grace for this argument is even stronger: As of now, BoJ banknotes in circulation are about JPY79 trillion, and long-term JGB holdings are about JPY63 trillion - leaving JPY16 trillion (3.4% of GDP) leeway, even within the current rule.
In short, the BoJ has much capacity to expand support for government deficits. This cushion is most likely to be used if the private sector hesitates to finance future deficits at ‘reasonable' yields. Which brings us to the crucial conclusion: The yen will weaken before JGB yields rise. (For the Morgan Stanley FX forecasts, please see FX Pulse).
6. Yen Weakens First in Any Fiscal Scenario
Let us finally consider the two scenarios for fiscal consolidation, call them Cautious Policy Scenario (CPS) and Aggressive Policy Scenario (APS).
In the CPS, there is no policy to end deflation, and no control of social benefits. Tax rates are raised, but worsened deflation prevents any rise of tax revenue, even as social spending rises. Deficits worsen, despite cuts of spending, which fall heavily on education and R&D, and hence prevent acceleration of productivity growth. Meanwhile, lack of electoral reform preserves the power of vested interests favoring the elderly. As a result, fiscal deficits expand further, deflation continues and even worsens, and nominal GDP continues to contract. The fiscal path becomes clearly unsustainable. Corporations move offshore at a faster pace, and the current account surplus evaporates. Confidence plunges, and even domestic savers move assets offshore. JGB yields start to rise. The BoJ is forced to monetize deficits, and inflation expectations begin to emerge. We argue that the yen will weaken immediately, while JGB yields would rise later but sharply. This difference of response is due to market structure.
Forex markets are atomistic and therefore hard for authorities to control. Hence, any change of outlook would be reflected quickly in forex markets. In contrast, the JGB market is oligopolistic; there are only a small number of large banks active in the short end of the curve, and a small number of large life insurance companies active at the long end of the curve. This oligopolistic structure slows reaction to news, allows authorities to jawbone for stability, and thus dampens response to small shocks. Small increases of yields are seen as temporary, and are met with increased buying. Hence, the increases really are temporary. In contrast, a shock that brings a large increase would be met with increased selling, as players struggle to reduce risk - leading to yet further rises of yields.
In the APS, electoral reform tilts the Diet away from the over-representation of the elderly, so that pro-inflation groups take more power. The government then prevails on the BoJ to expand monetary policy quickly. The BoJ insists on a quid pro quo of strict control of social benefits and reallocation of spending toward productivity-enhancing projects. The Diet agrees, in light of the new power of pro-growth interest groups. Accelerated productivity growth allows the current account to decline slowly, rather than quickly. In markets, the rise of inflation (in light of more aggressive BoJ policy) pushes yields up somewhat, but the sustainable path for the fiscal situation reduces the risk premium - especially if Japan acts earlier than Europe or the US. At the same time, however, higher inflation would weaken the yen, quickly discounting several years of relatively higher inflation in Japan. In this scenario, the weakening of the yen and the rise of JGB yields would be milder than in the CPS; nevertheless, because of the differences of market structure, forex markets would move earlier and more aggressively.
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