The run of key US economic data didn't end up being so much of a market focus with Europe back in crisis, but results were somewhat disappointing overall. The employment report was a positive surprise. Payroll growth was softer than expected in October at +80,000, but this was offset by upward revisions of 102,000 in September and August. And the unemployment rate fell to 9.0%, and hours and earnings results were solid. Prior to this, however, auto and chain store sales were weaker than expected, and both ISM surveys showed slight unexpected softening. The construction spending and factory orders reports pointed to a slight downward revision to 3Q GDP growth to +2.4% and +2.5% and significant reductions in automakers 4Q assembly plans as a result of more supply-chain disruptions and parts shortages led us to cut our 4Q forecast to +2.5% from +3.0%.
Downside risks remain significant, with fiscal gridlock continuing while the crisis in Europe is worsening again. Another week closer to its November 23 deadline and the super committee is still reportedly making no progress, the Washington Post reporting Thursday that "Debt-reduction super committee talks appear to be at an impasse". And there has been no movement (at least publicly) towards any efforts to reach agreement on near-term fiscal measures outside of the failing super committee framework. The Senate has continued to block the president's $447 billion stimulus plan attached to a tax hike on upper-income earners piece by piece in what appears to us to be much more of a political demonstration than a substantive effort to achieve anything. The latest proposals to be rejected were $50 billion in infrastructure spending and $10 billion to fund an infrastructure bank funded by a tax hike on higher earners on Thursday, with 51 Senators voting to move forward with debate on these measures, well below the 60 needed. At this point we appear increasingly to be headed towards expiration of the payroll tax cut and extended unemployment benefits at the end of this year, imparting material (about 1.25% of GDP) fiscal tightening at the start of 2012, and a failure of the super committee that would trigger substantial across the board (but relatively defense-heavy) spending cuts starting at the beginning of 2013 in addition to the scheduled expiration of all the Bush tax cuts at the start of 2013. Actual and prospective fiscal tightening and likely continued high levels of uncertainty could weigh heavily on growth at least through the November 2012 elections. Fiscal policy uncertainty has continued to put an increasing burden on the Fed to be prepared to act against downside risks. Fed Chairman Bernanke said at his press conference that large-scale MBS purchases were a "viable option" and "certainly something we would consider if conditions were appropriate". With the FOMC so divided at this point, Chairman Bernanke in his press conference role as representative of the whole FOMC was unable to provide any sort of framework that the Fed might use to judge "appropriate" conditions for further easing. There has clearly been a recent effort by a core of the FOMC to build the case for additional QE, however, probably focused on MBS buying. For this to receive broad enough support for the Fed to move forward, there would likely need to be at least stabilization in core inflation after the substantial acceleration seen over the past year and downside in growth relative to the FOMC's revised expectations. If we get a substantial slowing in growth in early 2012 with a push from fiscal tightening as we are currently forecasting, that would probably be enough of a trigger for an MBS QE3.
On the week, benchmark Treasury yields plunged 7-28bp, the first week of broad gains since the week of September 20-21 FOMC meeting, with the intermediate part of the curve leading. The 2-year yield fell 7bp to 0.23%, 3-year 12bp to 0.37%, 5-year 24bp to 0.88%, 7-year 28bp to 1.46%, 10-year 26bp to 2.04%, and 30-year 2bp to 3.10%. TIPS performed very well to keep pace with this surge in the nominal market even with the dollar broadly strengthening on renewed risk-aversion and record Japanese intervention and commodity prices coming under some pressure (front-month oil rose 1%, but natural gas was down 3% and copper 4%, and the overall CRB index declined 1%). The 5-year TIPS yield fell 24bp to -1.10%, 10-year 24bp to -0.09%, and 30-year 26bp to 0.73% after hitting a record-low close of 0.72% earlier in the week. Inflation expectations have remained very steady at levels consistent with the Fed's long-term goals and are not at this point providing support to the case for more easing, with the benchmark 10-year inflation breakeven dipping 2bp on the week to 2.13% and the 5-year/5-year forward breakeven implied by the Fed's constant maturity yields figures dipping slightly to near 2.30%. At the very short end of the market there had been a bit of elevation compared to September levels recently in overnight T-bill yields and repo rates, with bill yields trading slightly above zero and overnight Treasury general collateral repo rates averaging in low double-digit basis points in the first part of the week. But there was a renewed squeeze Friday, with the 4-week and 3-month bill yields rallying Friday to both end the week at -0.003% and the overnight general collateral repo rate moving down to an average of 0.065% from averages of 0.12% to 0.14% from Monday to Thursday. Mortgages trailed Treasuries a bit on the week, with some investors a bit disappointed that the FOMC didn't announce an MBS buying plan or more strongly hint that one is coming. But this still left current coupon MBS yields down about 20bp on the week to near 3.15%, a low in about a month. That should lead to average 30-year mortgage rates moving back below 4% in coming days, though there is still only a limited number of borrowers who can take advantage of that to refi because of tight lending standards imposed by the GSEs under the direction of the FHFA.
The employment report was broadly better than expected, though job growth continues to run at a pace that will only support a very gradual decline in the unemployment report. Non-farm payrolls rose a slightly lower-than-expected 80,000 in October, but there were sizeable upward revisions to September (+158,000 versus +103,000) and August (+104,000 versus +57,000). The upward revisions reflected more jobs tallied before adjustment, with revised seasonal adjustment factors in September and August actually subtracting 35,000. Other key details of the report were also positive. The unemployment rate dipped a tenth to a six-month low of 9.0%, as the much more volatile household survey's measure of employment surged again, rising 277,000 for average gains of 335,000 the past three months. The average workweek was steady at 34.3 hours, which combined with the modest rise in jobs resulted in aggregate hours worked ticking up 0.1% on top of an upwardly revised 0.5% surge in September. Average hourly earnings gained 0.2%, which along with the 0.1% gain in total hours worked combined for a 0.3% rise in aggregate weekly payrolls, a gauge of total wage and salary income. With the pullback in energy prices in October, this was a quite solid result in real terms, and it followed a 0.8% jump in September, the biggest gain since 2007, so income growth has looked quite solid in the past two months. While this report was better than expected, it still points to a sluggish labor market. Assuming a stable participation rate, the economy needs to generate 100,000-125,000 jobs a month just to keep the unemployment rate steady. Unless job growth starts to show some noticeable improvement from the average 126,000 so far this year and 114,000 in the past three months, the unemployment rate will continue to hover around 9%.
While the employment report was a positive surprise, the other key initial data for October were somewhat disappointing after the broad upside seen in the September data released last month. The manufacturing ISM composite index fell to 50.8 from 51.6, and while the drop was accounted for by a sharp pullback in the inventories index while orders improved, pointing to better results going forward, the result was still softer than implied by improvement in key early regional surveys. The non-manufacturing ISM was also marginally weaker at 52.9. Early indications of October retail sales pointed to a flattening out after the strength in September. Motor vehicle sales rose less than expected to 13.2 million units annualized after surging to 13.0 million in September from 12.1 million in August, while chain store sales results overall were disappointing and pointed to only a fractional rise for the key retail control grouping in the retail sales report after a 0.6% surge in September.
Revised 4Q assembly schedules released by automakers after they reported sales were also negative, with parts shortages again likely to weigh on output in coming months after the summer recovery from the severe supply chain disruptions in the spring after the disaster in Japan. Toyota and Honda said that they have been forced to cut back North American production significantly because of parts shortages caused by the flooding in Thailand. Ward's Automotive reported that GM and Chrysler have also had to pare 4Q assembly plans a bit because of parts problems unrelated to the situation in Thailand. Ford raised its output plans somewhat this month, but overall the industry is now planning to assemble a lot fewer vehicles in 4Q than it was a month ago. There will be a catch-up recovery when these latest parts shortages are resolved, but for 4Q we have cut back our estimate of the motor vehicle sector contribution to GDP growth by half a point (to only a marginally positive contribution even with significant upside in auto sales), lowering our 4Q GDP estimate to +2.5% from +3.0%.
The economic calendar is very light in the coming week, which will be shortened by the Veterans Day holiday on Friday (though the stock market doesn't recognize this holiday and will be open), and unless there is a sudden breakthrough by the super committee, there probably won't be much going on in the US to distract attention from the problems in Europe. Aside from developments there, Treasury market focus through much of the week will likely be on supply at the quarterly refunding auctions, $32 billion 3-year Tuesday, $24 billion 10-year Wednesday, and $16 billion 30-year Thursday. The curve has tended to have a steepening bias over the course of employment report Fridays after the initial reaction to the report as the Street looks ahead to 10-year and 30-year supply, but the Fed has a long-end purchase operation scheduled for Monday ($2.25-2.75 billion in the 2036 to 2041 maturity range) may have delayed set up for supply. The only particularly notable economic data releases are out Thursday, trade balance and Treasury budget:
* We look for the trade deficit to widen slightly in September to $46.0 billion, with exports up 0.7% and imports rising 0.8%. On the export side, there should be a rebound in capital goods excluding aircraft following a significant decline in August. Also, we look for price-related upside in industrial materials. On the import side, a modest rise in prices should be about offset by lower volumes to leave petroleum products little changed. Meanwhile, autos will likely pull back a bit more as production normalizes following a sharp recovery in July. BEA assumed a $2 billion widening in the September trade deficit in the advance GDP estimate, so our forecast of a $0.4 billion widening would imply an upward adjustment to the initially reported +0.2pp net export contribution to 3Q GDP.
* We forecast a decline in the federal government's budget deficit in October to $91 billion from $140 billion in October of last year. However, about half the swing reflects a calendar shift that accelerated some benefit payments into September. The remainder largely reflects higher withheld tax payments and lower defense spending.
Introduction
Outside of one or two exceptions where the growth outlook remains reasonably solid despite weak global - particularly European - growth prospects, CEEMEA economies are increasingly facing the undesirable duo of elevated inflation and mundane growth, placing their central banks in a policy bind that calls for extra heedfulness in the consideration of policy. While some have dared to proactively pursue an unorthodox mix of traditional policy and macro-prudential measures to deal with their idiosyncratic circumstances, others have felt it safer to adopt a wait-and-see approach. Given relatively close links with Europe, it is not surprising that CEEMEA FX has weakened recently in the wake of waning global risk-love and the general investor pessimism towards Europe. Such currency weakness, if sustained, will have important implications for forward-looking inflation outcomes, adding to the policy dilemma. In this piece, we attempt to quantify the pass-through from currency movements into CEEMEA inflation, and offer our thoughts on how individual central banks in the region are likely to respond.
This piece should be seen as a follow-up on our earlier research on the pass-through from oil and international food price shocks to CEEMEA inflation aggregates (see "CEEMEA: Food CPI on the Rise - Does it Matter for Central Banks?" CEEMEA Macro Monitor, November 29, 2010, and "Oil on the Up: Should Central Banks Worry?" CEEMEA Macro Monitor, March 14, 2011).
Framework of Analysis
To uncover the magnitude of the direct pass-through from currency movements to inflation, we estimate individual Phillips Curve equations for each of the selected countries under coverage, using simple OLS regressions. The standard sample set runs from 1Q00 to 2Q11, giving a total of 46 observations. Our dependent variable (goods inflation) is specified to relate to lags of itself (thus isolating potential inflation persistence and the backward-looking nature of price-setting in CEEMEA), as well as contemporaneous and lagged values of the nominal effective exchange rate and excess demand. The latter is proxied by a simple measure of the output gap. The regressions were run in step-wise format, assuming ex ante that current inflation is influenced by up to four lags each of past inflation, the output gap and the nominal effective exchange rate - the latter regressor being our primary variable of interest. This simplified framework imposes an element of consistency and comparability across the region, while contemporaneously allowing us to capture informative idiosyncrasies such as the unique pass-through lag lengths across each country.
As we are mostly interested in isolating the impact of currency movements on inflation, we run a two-stage process where we first specify the dependent variable as goods inflation (given that currency movements mostly impact on inflation via the tradeable goods channel). The estimated coefficient is then weighted by the share of goods in the inflation basket. Within our sampled CEEMEA economies, goods accounts for roughly two-thirds of the inflation basket - although the weight is ostensibly higher in CEE, Russia and Turkey (see Appendix in the full report).
Second, we add on our subjective guesstimate of the impact of currency movements on services inflation. On average, the size of this second transmission channel is roughly two-fifths of the direct pass-through from FX to goods inflation. Combining our empirical goods and services pass-through coefficients provides us with our overall headline CPI elasticity coefficient.
Summary of Our Findings
The results of our estimations show that, within the CEEMEA region, Israel has the highest FX pass-through of some 19%, followed by the Czech Republic (13.7%), Romania (13.5%) and Turkey (12.6%). Interestingly, South Africa comes in at the bottom of the range (5.0%), suggesting that its economy is in fact relatively well-insulated from FX moves. We provide a country-by-country discussion below.
South Africa: Weak Pass-Through Helps to Limit Policy Swings
We find that goods inflation in South Africa is best explained by a single period lag of itself (some indication of backward-looking inflation expectations), a one-period lag of the nominal effective exchange rate and a three-period lag of the output gap. All variables are statistically significant and have the correct signs. That the currency affects inflation before the output gap does makes intuitive sense, considering that imported goods may re-price almost immediately, while inflation usually takes time to respond to changes in demand. Our results point towards a pass-through from FX to headline inflation of some 5.0%, which is at the lower end of the 4-14% range that other studies have shown. Not only is the long-run pass-through coefficient low for South Africa. Our empirical results show that it has also declined somewhat in recent years.
We attribute the decline in FX pass-through to the combination of higher margin absorption (i.e., lower mark-ups) by import distributors as trade openness improved, and as the SARB's inflation-targeting framework gained credibility, thereby anchoring inflation expectations. Retail margin squeezes may have intensified as realised inflation outcomes began to converge with inflation expectations in the second half of the 2000s.
Importantly, we find that although South Africa has a relatively high FX volatility, its CPI volatility is broadly in line with the regional average, thereby obviating the need for potentially disruptive policy swings, thanks in large measure to its much lower FX pass-through. This is quite different from Turkey, where high FX volatility has translated into relatively high CPI volatility, thanks to relatively high pass-through.
Finally, we note that South Africa's output gap coefficient is the highest in the sample, suggesting that domestic demand conditions here could meaningfully exaggerate or offset the initial pass-through impact of a given currency move on inflation.
With regards to policy, our analysis suggests that the recent 10-15% depreciation in the ZAR could add roughly 0.1-0.3pp to our inflation forecast, if one considers the additional impact of higher international oil and food prices (near-term maize futures prices have soared 75% since the start of the year, and are bound to place a floor under food prices in the coming 6-9 months). As a result of a high and sticky inflation outlook, we maintain our baseline view of an on-hold policy stance through 2012.
Turkey: Dynamic Monetary Policy
The Central Bank of Turkey has published numerous papers on the empirical pass-through from TRY movements to core and headline inflation. Before the recent global crisis and especially prior to Turkey's switch to an explicit inflation-targeting regime in 2006, the pass-through effect from the exchange rate to headline consumer price index was believed to be approximately 30% over a 12-month period. Similar to South Africa, however, the adoption of an explicit inflation-targeting regime appears to have combined with a post-crisis decline in the rate of ‘dollarisation' to place a lid on FX pass-through. According to the most recent estimation results published by the CBT, the impact of lira pass-through on core inflation has fallen to some 15% over the first year, with 80% of the pass-through taking place in the first nine months. Using a conversion ratio of 82% (share of core inflation in total CPI) implies a pass-through coefficient of some 12% into headline CPI - assuming that services/non-tradeables are completely impervious to currency movements.
Our own estimate of the FX pass-through to Turkey's tradeable goods CPI is 14.9% - pretty much in line with that of the CBT (although we use different estimation methods). For headline inflation, we estimate a weighted pass-through of 12.6%.
Of importance for policy is the fact that the CBT has a certain tolerance for currency volatility and, when the depreciation in the currency exceeds a certain limit, the CBT acts. This is not to say that the monetary authority has anything against an orderly depreciation in the currency, especially when there is a sizeable output gap which is believed to be offsetting the FX pass-through to a significant extent, not to mention the wide current account gap. In fact, since the beginning of December 2010, the CBT deliberately employed a non-standard policy approach to weaken the currency, until the disorderly move dominated the scene starting early August.
Historically, various currency depreciations and the resulting pass-through episodes were rather transitory as the duration of the currency weakness remained limited. This was mostly dealt with via higher interest rates that either drew foreign capital or triggered reverse currency substitution (de-dollarisation) by locals. We believe that the recent episode that led to FX sales, interventions and the eventual tightening of liquidity conditions stemmed from the rather long duration of currency weakness amid relatively low interest rates, which posed a bigger threat to maintaining price stability (and anchoring expectations). The decisive actions by the CBT in recent weeks have been a result of this and are likely to be maintained until volatility in the currency subsides and inflation expectations stabilise or converge towards the medium-term target of 5%.
Czech Republic: No Need to Worry...Yet
For the Czech Republic, we estimate that up to 17% of FX movements find their way into local goods prices over a period of 12 months. For headline inflation, we estimate a total pass-through of some 13.7%. This is broadly in line with the latest guidance on the FX pass-through to headline CPI by the CNB, which is 15%. The FX pass-through is very important in the Czech Republic, not least because of its relatively high trade openness (exports are over 80% of GDP). As a rule of thumb, a 3% move in CZK versus EUR is roughly equivalent to the impact of a 100bp move in interest rates.
The koruna has only weakened marginally in recent weeks (both against EUR and versus other CEE currencies), as investors have come to consider the Czech Republic as a ‘safe haven' within CEE. For this reason, and the fact that Czech inflation expectations are well-anchored, we do not expect the CNB to react to weaker FX. If anything, it seems to us that the central bank has an explicit preference for more koruna depreciation (see also CEE: Trip Notes (Oct 10-12), October 18, 2011).
Hungary: It's Not Even about Inflation Any More
For Hungary, our estimate of the FX pass-through of just under 13.5% to goods CPI and some 11% to headline inflation is not that far from NBH guidance of around 15% for headline CPI. We must point out that our results for the Hungarian FX pass-through may have been compromised by its volatile tax policy regime recently, compounded by significant changes in administered price-setting. Under such scenarios, estimating ‘underlying inflation trends' is rather difficult. Note that the bank has sounded worried about the recent move weaker in HUF (14% versus EUR since July), not just in terms of its inflation consequences, but mostly because of the large stock of un-hedged household borrowing in foreign currencies (currently at 20% of GDP - the highest in CEE). We continue to believe that the NBH will deploy FX intervention rather than hike rates in emergency fashion, like it did in 2008. But we keep our view that as long as the risk environment is fragile and the FX loan stock remains an issue, the NBH has no room at all to cut rates.
Poland: PLN Weakness to Lift CPI Trajectory, Delaying Cuts
Our estimate of a 10% pass-through to goods inflation (8.4% to headline CPI) is well below the NBP's guidance of a 20% pass-through to headline CPI over the cycle. The official guidance appears high to us, especially in light of the fact that other central bank estimates in CEE are in the 15% region, and Poland is a more closed economy than its peers. Nevertheless, the fact that our output gap variable actually came out wrongly signed suggests that our own estimated coefficients may themselves be subject to specification bias too. For example, our relatively low pass-through coefficient may understate the true pass-through due to the fact that, over the surveyed period, Poland enjoyed substantial productivity growth during times of strong GDP growth (e.g., in 2004-08). This, coupled with wage moderation, implied falling ULC growth, and hence downward pressure on core inflation. The absence of the latter variables from our standard specification may have impacted the size of the primary independent variable.
The NBP cares about PLN as excessive depreciation may put the banking system under strain. Besides this, it is likely that the recent move weaker in PLN (9% versus EUR since July) may imply an upward revision in the official NBP inflation forecast (out in November), which may delay rate cuts in the eyes of the market. This does not mean that the NBP will not be cutting rates in 2012, though we still expect it to start focusing more on slower growth, as inflation eases in early 2012 due to base effects. Our call is still for 50bp of rate cuts in 1H12.
Romania: RON Resilience Gives NBR Room to Manoeuvre
The overall estimate of a 15% pass-through to goods CPI and 13.5% to headline inflation for Romania appears to be on the low side. Empirically, we have observed that, although the weight of services in headline CPI is rather small (about 20%), the observed pass-through from FX moves into services CPI is often quite high. Romanian authorities care about RON for the same reason that Hungarian authorities care about HUF: a large stock of un-hedged FX borrowers and the portfolio quality deterioration that comes with a weaker FX. That said, the fact that RON (far less liquid than other CEE peers) has held up much better than HUF has allowed the NBR to start cutting rates (25bp, this week), in contrast with Hungary, where this option is not on the table. We see another 50bp of rate cuts in Romania (to 5.50%), concentrated in 1H12.
Israel: Pass-Though Likely Overstated
Our estimates point to an overall FX pass-through to headline inflation of around 19%. This is much higher than the unofficial Bank of Israel estimates of some 14-15% that have been discussed in various conferences and meetings. In fact, given the significant rise in the use of the shekel in most domestic contracts, especially in that of housing rent (which used to be around 50-60% in USD and is now almost entirely in ILS), we believe that our regression outcomes may overstate the true pass-through.
Russia: Where the Past and Future May Differ
In Russia, imported goods are about 15% of household consumption, with imports being 9.3% of food consumption and almost 30% of non-food consumption. We estimate that a 10% depreciation in the nominal effective exchange rate results in a 1.4% increase in goods prices (1.1% for headline CPI) in the long term.
Looking forward, we see two major complexities in forecasting the FX pass-through in Russia:
• Exchange rate regime: Russia is in the process of moving from a managed to a floating exchange rate regime. In the past, the managed exchange rate reduced the level of FX volatility in normal times, but also led to an occasional large movement in the FX rate when the exchange rate commitment became unsustainable.
As a result, when RUB came under pressure which was resisted, as in autumn 2008, the CBR interventions could tighten policy and act as a drag on inflation, offsetting the increase in inflation from FX pass-through. But when RUB came under pressure and the CBR allowed the FX rate to adjust, as in January 2009, it might then also loosen policy following the adjustment, adding to the increase in inflation from FX pass-through. In other words, the monetary impact of the exchange rate commitment might offset or amplify the initial inflationary impact of FX changes. Now, with a more flexible exchange rate, we expect to see a cleaner and more direct pass-through from FX changes to inflation in future.
• Import substitution: Russian consumption of imports is very sensitive to dollar incomes, reflecting the fact that most essentials (fuel and basic food) are produced domestically and imports tend to be superior goods, which you buy more of as your income rises. As a result, imports have fallen sharply when dollar incomes have fallen following a devaluation, with consumers switching to cheaper domestic substitutes. In our view, this high sensitivity of imports to dollar incomes explains why Russian imports fell faster than exports through the 2008-09 crisis, preserving the current account surplus even as the price of oil fell dramatically. This behaviour may, in turn, reduce the level of FX pass-through in the long term.
We believe that these uncertainties are behind the CBR's reference in its monetary policy statement on October 28 that it would continue to monitor the effects of a weaker RUB on inflation.
Incidentally, we believe that Russia's ‘wrongly' signed output gap is linked to the events of 2009, where the January 2009 devaluation was followed by a sharp contraction (-7.8%). The depth of the contraction was in our view not due to the devaluation itself, but rather to the impact of a lower oil price and the tight policy - including high rates and tight fiscal policy - pursued in autumn 2008 in an effort to defend RUB.
For most of the year, inflation has been the biggest concern among investors, as many are worried that the upward trend would not be reversed. We have long argued that although Brazil has a serious inflation problem, it was exacerbated supply shocks last year and earlier this year that increased headline figures significantly. Although we have had only one inflation print that showed a decrease in yearly figures - October IPCA-15 declined from 7.3% to 7.1% - we believe that this is just the start of a trend. While this is certainly good news and should calm fears that inflation would run ever higher, this does not mean that Brazil's structural inflation problem is over. We think that the path needed to achieve significantly lower inflation on a structural basis is viewed as too costly by the current administration, which has very clear growth goals. This does not mean that Brazil will lose control of inflation, but it does keep the risk of inflation risk in the debate and reminds us a bit of Brazil's more distant past.
Favourable Base
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