Brazil
Mind the Current Account Gap?
February 02, 2010

By Marcelo Carvalho | Sao Paolo

While Brazil's recent currency market jitters are related to global factors, including concerns about China, we suspect that Brazil's own current account deficit could also start to grab the market's attention this year. As Brazil's economy rebounds, import growth should outpace export recovery, and the trade surplus should narrow, while rising domestic corporate profitability is likely to fuel rising outflows of profits and dividends, turning the overall current account balance more sensitive to the business cycle. The end result: the current account deficit can easily double this year, to about 3% of GDP in 2010. While not worrisomely large yet, especially if its financing can count on rising foreign direct investment, a widening current account deficit could eventually start to raise some question marks if it turns into a persistently worsening trend.

Current Account Set to Worsen

The trade surplus could vanish this year, with a rebound in imports quickly outpacing the rate of growth of exports. The trade surplus ended last year at US$26 billion, little changed from 2008 - although both exports and imports fell sharply amid the downturn in Brazil and abroad. While the central bank looks for a declining trade surplus of US$15 billion in 2010, we suspect that it could narrow even more, shrinking close to zero this year. While we expect exports to expand with the recovery in global demand, we believe that Brazilian imports will grow even faster than exports as domestic demand outpaces global recovery and the currency remains relatively strong.

While the outlook for international trade prices is uncertain, there is less doubt about where trade volumes should head from here. To be sure, the trade balance can benefit from rising export prices - which in Brazil's case correlate fairly well with international commodity prices. All else equal, a 1% swing in annual average export prices can represent a change equivalent to 0.1% of GDP in the Brazil's trade balance - although the final net impact in Brazil's terms of trade can be partially offset by import prices, which sometimes show some partial correlation with export prices too. While terms of trade can prove erratic, there is little question that import volume expansion should easily outpace export volume growth this year, judging by domestic demand growth differentials.

Besides the trade balance alone, other current account items are also likely to worsen along with the business cycle upswing this year. While often overlooked, current account services now play an increasingly important role in the overall current account outcome. Indeed, significant changes in the composition of services over the years mean that the current account balance has probably become more sensitive to the business cycle over time. A decade ago, Brazil's burden of interest payments on its external debt used to be the single largest item in the current account. As interest payments were relatively steady and normally insensitive to the domestic business cycle, cyclical swings in the domestic economy would typically filter through the current account mostly through the trade balance. This picture has changed. Now, the burden of external interest payments is relatively much smaller. By contrast, other current account items like profits and dividends have gained much larger importance in recent years.

Indeed, the outward remittance of profits and dividends has now become a much more relevant piece of the overall current account. Profit remittances and dividend payments have gained importance in part as the cumulative stock of foreign direct investment inflows over recent years has grown. Swings in the remittance of profits and dividends also seem to reflect cyclical considerations - when the domestic economy does well, and profitability is on the rise, it is only natural to expect that there are more profits and dividends to be sent abroad. These international transfers can prove particularly welcome at multinational headquarters when business conditions are challenging back home, in the country where the initial investment came from. In addition, there may be a translation effect - the dollar impact on the current account from domestically generated profits can get magnified when the exchange rate is stronger. In all, net outflows of profits and dividends slowed with the domestic economy to US$25 billion in 2009, from US$34 billion in 2008, but look set to increase again in 2010 as the economy rebounds.

In other words, we suspect the current account balance may have become more sensitive to the business cycle. This is good news when external financing dries up and domestic demand has to adjust in order to curb the current account balance. But it might also magnify the worsening in the current account deficit during the cyclical domestic growth upswing.

The upshot - we believe the current account deficit will worsen substantially. To put it simply, the current account balance tends to worsen when the domestic economy rebounds - as historical correlations illustrate. The current account deficit can easily double this year from a deficit of US$24 billion in 2009 - the central bank looks for a current account deficit of US$40 billion in 2010, but we worry the deficit could easily exceed the US$50 billion mark. The median market consensus forecast for the current account deficit has been worsening steadily over the last several months, and we fear that it could slide further.

Indeed, 2010 looks set to produce Brazil's largest nominal current deficit on record, at least in US dollar terms, although economic growth over the years and a strong currency help boost real GDP estimates in dollar terms, thereby curbing the deficit when measured as share of a rising GDP. In our forecasts, the current account deficit will widen from 1.6% of GDP in 2009 to around 3% of GDP in 2010.

FDI to the Rescue?

A current account deficit of 3% of GDP does not sound too worrisome by international standards. Brazil itself already saw larger current account deficits in its own past - as large as in the 4-5% range, during the turbulent days of the late 1990s.

And to be clear - there is nothing necessarily wrong in running a current account deficit, particularly in the case of a savings-hungry, emerging market like Brazil. In fact, Brazil has run a current account deficit for most of its modern history - it has posted a deficit in 50 of the 62 years since the start of the records in 1947. Brazil had has a current account surplus in only 12 years, five of which were during 2003-07. Current account surpluses in Brazil should be seen as the exception, not the rule.

Happily too, foreign direct investment (FDI) should go a long way in financing the current account deficit. FDI slowed from US$45 billion in 2008 to US$26 billion in 2009, but should bounce back going ahead, resuming levels seen back in 2008 (see "What Is the FDI Outlook?" This Week in Latin America, September 21, 2009).

So, why worry? While the likely magnitude of the current account deficit this year does not yet look worrisome, especially if mainly financed by rising FDI, the deficit may eventually start to raise some question marks if it keeps deteriorating further, as this could leave Brazil increasingly more dependent on foreign capital inflows, and thus vulnerable to potential sudden stops in international flows. That is, while a current account deficit of 3% of GDP is not alarming, its worsening trend might eventually become a concern.

Currency Implications

If the recent wave of market jitters proves temporary, international conditions could still support the real. For instance, abundant global liquidity could help spur international commodity prices, which in turn can support Brazil's terms of trade and underpin the real. Also, favorable growth differentials can help to attract capital inflows, especially in the form of equity and FDI flows, as long as international risk appetite is sufficiently strong. Keep in mind too that Brazil's currency moves must be seen in a global currency context that takes into account what the US dollar itself does against other currencies. In other words, swings in the real over the last year or so have often been less dramatic against a broad basket of currencies than bilaterally against the US dollar alone. All things considered, our end-2010 forecast continues to assume the real at R$ 1.70 per dollar.

However, prospects for a widening current account deficit could eventually start to weigh on the currency, all else equal. After all, the real does not look cheap by historical standards, as most usual valuation measures would appear stretched as of late. For instance, the currency has been stronger than long-run averages, when measured against a basket of currencies in Brazil's main trade partners and adjusted for inflation differentials - or the so-called real effective exchange rate. For its part, the political calendar can add volatility to the currency, if it affects country risk perceptions going into general elections in October 2010. In addition, restrictions like last October's IOF tax on capital inflows fit a larger picture - the broader concern is that there is an ongoing policy shift away from orthodoxy and towards a more interventionist approach. For investors, the potential threat that the Treasury could also intervene in the foreign exchange, buying US dollars in the spot market, on top of what the central bank already does, seems to work against the notion of much currency appreciation, at least in the near term.

Bottom Line

While recent market jitters reflect global factors, Brazil's own current account deficit could start to grab the market's attention later on. Amid robust domestic growth, the current account deficit is set to widen significantly this year. While rising foreign direct investment should help finance the gap, a worsening current account trend might start to raise some question marks, if it leaves Brazil more vulnerable to potential swings in foreign capital flows.

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United States
Review and Preview
February 02, 2010

By Ted Wieseman | New York

Treasuries ended the past week little changed, supported by a flight-to-safety bid through the week - direct and through the negative impact stocks and other risk markets - on concerns about Greece's budget and financing situation.  Swings in sentiment about Greece caused the defensive bid in Treasuries to come and go through the week, with a more relaxed outlook for a couple of days after heavy demand at Greece's 5-year debt sale Monday giving way to renewed concerns starting Wednesday, with the volatility added to by various pieces of press speculation and claims about support for Greece from the EU or China that were met with official denials.  For the week as a whole, the spread of 10-year Greek debt over 10-year German bunds widened about 60bp to near 365bp after holding little changed Monday and Tuesday, gapping out 90bp Wednesday and Thursday, and then narrowing 30bp Friday.  Concerns about the pace and potential impact of policy tightening in China also remained a global market concern, with more reports of moves by bank regulators to restrain lending hitting Asian stock markets particularly hard early in the week, with some spillover into US markets.  Domestically, politics were more of a focus than economics, and news was better in the latest week, with Fed Chairman Bernanke being ultimately confirmed by the Senate to another term by a comfortable margin and the State of the Union speech not containing anything new that was significantly market-negative in either substance or tone after concerns the prior week about the rising anti-bank sentiment tone in Washington had led to big losses by financial stocks.  With the focus on policy in Greece and China and on politics at home, domestic economic news didn't have much market impact.  Economic news was somewhat mixed but mostly positive.  GDP was even stronger than expected in 4Q at +5.7%, and with the upside coming from final demand instead of an even bigger-than-expected boost from inventories, there were no negative implications for 1Q.  Indeed, a stronger-than-expected durable goods report that showed big upside in capital goods orders and shipments in December pointed to upside risks to business investment in 1Q, which could be added to by a reversal of a drop in volatile federal defense spending in the 4Q GDP report (the main unexpected negative in the figures).  Together these two areas suggested some possible upside to our previous +2.5% 1Q GDP forecast.  With growth surging in 4Q and on pace for solidly positive, if likely notably slower, 1Q growth and employment expected to turn sustainably positive in Friday's employment report, the FOMC's highly cautious policy outlook, continued focus on downside instead of upside inflation risks, and refusal to start moving towards an exit strategy from its super-dovish monetary policy by continuing to predict "exceptionally low levels of the federal funds rate for an extended period" was generally unwelcome by the fixed income markets, though certainly not surprising.  A dissent against this extremely easy-money policy by long serving Kansas City President Hoenig, however, was surprising, and briefly led to a flattening of the yield curve and a reduction in inflation expectations in the TIPS market.  This sentiment soon largely dissipated, however, helping TIPS to resume outperforming and the curve to steepen back out, as investors figured that Hoenig was probably well outside the dovish FOMC consensus. 

On the week, benchmark Treasury yields ended up little changed, but small front-end gains and minor long-end weakness moved the curve a bit steeper.  The old 2-year yield fell 3bp to 0.78%, 3-year 1bp to 1.36%, old 5-year 3bp to 2.31% and old 7-year 1bp to 3.06%, while the 10-year yield rose 1bp to 3.61% and the 30-year yield rose 0.5bp to 3.51%.  Flight-to-safety flows and continued supply constraints after a more than US$100 billion bill paydown in January kept the very short end squeezed, with the 4-week bill yield closing below zero three of five days and ending the week at -0.01%.  TIPS mostly outperformed on the week after investors decided Thursday and Friday that the KC President Hoenig was unlikely to be able to convince the rest of the FOMC away from super-easy money any time soon.  The shorter end of the TIPS curve did lag somewhat, as the dollar rallied significantly with help from the Greece situation and the GDP strength that emphasized US growth outperformance within the G3, and this, in turn, contributed to further pressure on commodity prices.  TIPS are generally most sensitive to oil price moves, and oil held up comparatively well, with the March contract off 2% to US$72.89 a barrel as domestic economic strength provided some support.  Much bigger weakness was seen in metals prices, with the LME's composite index down 7.5%, since worries about the impact of a possible slowdown in China's demand are especially pronounced in this area.  For the week, the 5-year TIPS yield fell 2bp to 0.20%, 10-year 2bp to 1.28% and 20-year 3bp to 1.92%.  With Treasuries benefiting from flight-to-safety flows, spreads mostly widened a bit versus other interest rate markets, though agencies held in well.  Mortgages lagged a bit, however, with current coupon yields marginally lower at around 4.35%, a level they've held quite close to for a couple of weeks now and which should keep average 30-year mortgage rates near current 5% levels.  This fairly tight, roughly 200bp, spread over 5-year Treasuries hasn't really moved much at all as the Fed has slowed its MBS buying in recent months.  The Fed owns such a large share of the MBS market at this point that the stock impact of its buying is likely to help support the market long after its flow of buying ends.  Swap spreads also widened a bit on the week. 

US risk markets traded softer on the week, but more notable probably than the small outright loss was a shift towards comparative resilience versus major overseas markets.  The S&P 500 lost 1.6% on the week, a smaller sell-off than was seen in Europe or Asia, the former hit harder by worries about Greece and the latter by concerns about the possibility of further tightening steps in China.  With concerns about a further intensification of proposals and rhetoric perceived as hurting banks not being realized at the State of the Union, financials held up well, ending the week close to unchanged after a 5% drop the prior week.  Instead, the latest week's weakest sectors were basic materials (-5%), energy (-3%) and technology (-3%) in response to the further declines in commodity prices and disappointment with some major earnings releases.  There were some more meaningful intraday moves, but on a closing basis, credit hardly budged all week while stocks were seeing greater volatility.  On net though, the result wasn't too different, with small losses also for the week.  In Friday afternoon trading, the investment grade CDX index was 1bp wider for the week at 97bp, and the high yield index was seeing small losses on the day to move slightly into the red after closing a minor 7bp tighter on the week at 568bp Thursday.  The leveraged loan LCDX index had been holding up a lot better than HY CDX through the first few weeks of the month, but lagged in the latest week, widening 22bp to 453bp through Thursday and extending the losses somewhat Friday.  On the positive side, the commercial mortgage CMBX and subprime ABX markets did better the past week after a bad prior start to the year.  The AAA CMBX index fell another 1% on the week for a 3% year-to-date drop, but the junior AAA held about unchanged and the AA gained 1% to leave their drops for the month at -8% and -5%, respectively.  The AAA ABX index did better, gaining 2% on the week to sit about flat for the month now.  Meanwhile, Greece's problems are making investors more worried about sovereign credit risk globally, including for US, putting continued pressure on muni bond default swaps the past week.  There's clearly no direct connection, but Greece's budget position within the EU and its lack of political control over the central bank setting its monetary policy is reasonably analogous to a state's position in this regard within the US and in relation to the Fed.  And there are certainly some US states with budget imbalances that look as tough as Greece's.  In Friday trading, the 5-year MCDX index was 5bp wider on the week at 170bp, about double the recent tights seen in October. 

Real GDP surged at a 5.7% annual rate in 4Q, the strongest quarter since 3Q03.  As expected, most of the upside reflected a sizable production catch-up to improving demand that caused inventories to add 3.4pp.  Note that inventories were still liquidated, just at a much slower rate than in 3Q, so there's no reason to look for an imminent payback in 2010.  Final sales gained 2.2%, supported by a 0.5pp add from net exports, as export growth (+18.1%) outpaced imports (+10.5%).  Final domestic demand rose 1.7%, hurt by a 0.2% decline in government that was partly a result of a drop in volatile federal defense spending, which will likely be more than reversed in 1Q.  Modest growth was seen in consumption (+2.0%) even with a big payback in motor vehicle sales, business investment (+2.9%) as a big gain in equipment (+13.3%) offset continued major weakness in structures (-15.4%), and residential investment (+5.7%).  Looking to 1Q, the sharp run-up in capital goods shipments in December seen in the better-than-expected durable goods report - non-defense capital goods ex aircraft shipments gained 2.2% in December on top of an upwardly revised 1.6% increase in November - provides a stronger starting point for equipment investment, which could run closer to 4Q's +13% than our last forecast of +4%.  Government should also receive some added support from a rebound in defense.  And we continue to see inventories adding a bit more to growth in the current quarter, in large part reflecting what should be another quarter of big upside in motor vehicle output, after this small sector added 1.6pp to 3Q GDP growth and 0.6pp to 4Q.  So, the initial trajectory for 1Q growth looks somewhat better than our current official forecast of +2.5%. 

Other data released the past week leading up to the GDP report were somewhat mixed.  On the positive side, along with the strong durables report, which showed big gains in capital goods orders and shipments in November and December that provided a strong trajectory for equipment investment coming into 2010, consumer confidence showed solid improvement in January.  Of particular note was a significantly less negative view of current labor market conditions in the Conference's Board's survey.  The percentage of respondents describing jobs as plentiful rose to 4.3% from 3.1%, while the percentage describing jobs as hard to get fell to 47.4% from 48.1%.  This was the least negative net view since August.  Over time, this question matches up reasonably well with trends in the unemployment rate, and the recent improvement suggests the unemployment rate may have peaked at 10.1% in October.  Also positive through the week were the remaining regional manufacturing surveys before the ISM report on Monday, with the Dallas Fed, Kansas City Fed and Chicago PMI surveys all showing good upside in January.  As a result, we left our ISM forecast at 56.0 even after annual seasonal factor revisions lowered the December reading to 54.9 from 55.9. 

On the negative side of the week's data, the payback in home sales late last year has been somewhat more severe than expected after demand was pulled forward into the summer and autumn ahead of the initially scheduled expiration of the homebuyers' tax credit.  New home sales fell 7.6% in December for a 16% drop in the last two months of 2009 after a 24% gain from the January record low through October.  Existing home sales, which are less timely than new since they are reported at closing instead of contract signing, plunged 17% in December after a 28% surge over the prior three months.  Even with sales pulling back, inventories of unsold homes continued plunging, with existing down 7% and new 2%.  Continued moderation in inventories ahead of the key spring selling season should continue to put a bottom under home prices if sales start moving higher again after this correction.  And the eventual extension and expansion of the tax credit and near record low interest rates should boost sales going forward.  Improvement in labor market conditions should also be supportive, though there was some uncertainty about the pace of recovery in January after a smaller-than-expected pullback in initial jobless claims in the latest report.  After the release of the prior report, the Labor Department said that an unexpected surge in claims was "administrative" instead of "economic", since it was caused by a short-staffed state employment office clearing backlogs of filings that had built up over the holidays.  Lagged state-by-state data supported this, since the entire national gain was accounted for by a huge rise in California.  So it was unclear why claims didn't pull back more in the latest report.  The Labor Department didn't comment this week, and state details are only available with a one-week lag.  For now we continue to forecast a 75,000 rise in payrolls and a dip in the unemployment rate, but we want to see in the coming week's claims detail whether it is just distortions in California keeping filings high or whether there have been signs of worsening more broadly across the country. 

The upcoming week is again quite busy, and while any further news or market fallout from Greece's fiscal situation or China's bank lending restraint will remain major market focuses globally, the domestic economic calendar will probably also be more closely watched as we get the early run of key January data, which we expect to show solid results.  After having just gotten through US$118 billion of 2-year. 5-year and 7-year supply, investors will also have to deal with more supply news at Wednesday's quarterly refunding announcement.  In January, Treasury retired a big chunk of the bill market while raising large amounts of money in coupons, continuing its effort to extend the average maturity of the debt, but causing the distortions in bill trading, with 4-week yield trading negative frequently recently.  At current issue sizes, the Treasury will continue to raise more than enough new money in coupons going forward to meet its financing needs and continue over time to reduce bill supply (though after this Thursday's paydown, bill issuance should turn positive for a time during the seasonal peak financing needs of tax refund season).  We look for nominal note and bond sizes to hold steady at current record levels for now, so we expect the refunding to consist of a US$40 billion 3-year, US$25 billion 10-year and US$16 billion 30-year, which would raise US$33 billion in new money.  TIPS issuance, on the other hand, will likely continue to move somewhat higher.  The shift from 20-year to 30-year TIPS was announced at the November refunding, with the first revived 30-year TIPS auction at the end of February.  The Treasury also said in November that it was considering increasing the frequency of TIPS auctions from the current eight a year - two new 10-years, a 5-year, and now a 30-year, all reopened once six months after the initial sales.  It's possible that an expansion of this calendar towards monthly issuance could be announced on Wednesday, with the potential introduction to start of a second new 5-year to the annual issuance calendar.  Data focus will be on the key early numbers for January - employment Friday, manufacturing ISM Monday, motor vehicle sales Tuesday, non-manufacturing ISM Wednesday and chain store sales Thursday.  Other releases due out include personal income and construction spending Monday, and productivity and factory orders Thursday:

* We forecast 0.3% gains in both personal income and spending in December.  The employment report pointed to another modest rise in December income.  Meanwhile, the retail sales data were consistent with some moderation on the spending side.  This combination implies a steady personal saving rate.  Finally, our translation of the CPI data points to a 0.10% rise in the headline PCE and a 0.08% increase in the core PCE, which should put the year-on-year rate at +1.5%.

* We expect the manufacturing ISM to rise to a robust 56.0 in January.  On an ISM-weighted basis, almost all of the regional results showed decent gains.  The only exception was the Philly Fed, which was close to unchanged.  So we look for about a 1-point rise in ISM relative to the revised reading of 54.9 seen in December.  In particular, we look for gains in the employment and inventory components.  Finally, the price gauge is expected to rise about 1.5 points (to 63.0).

* We look for a 1.0% drop in December construction spending.  Weather conditions were unusually mild through early December but took a turn for the worse across many parts of the nation as the month wore on.  This likely restrained activity in both the residential and non-residential sectors.  In fact, the December housing starts report showed an unusually large decline in the number of homes under construction.  So, we look for a sharper drop-off in overall construction spending than seen in recent months.

* We expect January motor vehicle sales to decline to a 10.8 million unit annual rate.  The wind-down of promotional activity, weather-related factors and the well-advertised problems at Toyota are all expected to contribute to a sequential dip in the sales pace relative to the 11.2 million unit rate registered in December.

* We forecast a 7.5% gain in 1Q productivity and 5.0% drop in unit labor costs.  The strong GDP results, combined with a slight decline in hours worked, point to another surge in productivity growth following the 8% spike seen in 3Q.  On a year-on-year basis, productivity is expected to climb to +5.7% - the best since early 2002.  Meanwhile, unit labor costs seem poised for another sharp drop in the quarter and appear to be running at close to -3% on a year-on-year basis.  Obviously, a big part of the productivity and cost story at this point is related to normal cyclical dynamics.  But we suspect that policy uncertainty may also be contributing to employers' resistance to add more labor inputs.

* We look for a 0.4% rise in December factory orders.  The durables report pointed to a slight rise in overall factory bookings.  Meanwhile, shipments should post a larger gain (+1.4%), and inventories are likely to reverse their recent upticks (-0.5%).

* We forecast a 75,000 gain in January non-farm payrolls.  There are four key factors impacting our expectation for the January employment report: 1) our estimate for the impact of unusually severe weather on December payroll employment (around -50,000);  2) a return to relatively normal weather conditions during the January survey period, as seen in the heating degree day series available from the National Oceanic and Atmospheric Administration; 3) the modest underlying improvement in labor market conditions, as reflected in the 20,000 dip in the 4-week average of initial claims relative to the December survey period; and 4) an estimated census effect of +25,000 (see US Economics: Say Goodbye to the Job Recession...Say Hello to the Census Effect, January 8, 2010, for more details on how this special factor is likely to play out over the course of the coming months).  Incorporating all of these items, our forecast for January payrolls is +75,000 (or +50,000 ex-census).  Finally, the household survey is also expected to show a rebound in employment this month.  This comes on the heels of some very sharp declines over the course of recent months that appeared somewhat overstated.  Such a correction is expected to trigger a slight decline in the unemployment rate.

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United States
Mind the Gap: Even Record Slack in the Economy Won't Crush Inflation
February 02, 2010

By Richard Berner, David Greenlaw, Ted Wieseman, David Cho | New York

Disinflation risks limited.  Record ‘slack' in the economy - a 10% unemployment rate, a 7% output gap, and operating rates lingering below the levels in past downturns - suggests near-term downside risks to inflation.  Indeed, although rising energy quotes have boosted headline inflation back to as high as 2.8%, measured by the CPI, ‘core' inflation by any metric is now at or below the Fed's presumed comfort zone of 1.5-2%.  But in our view, those downside risks are limited: The slack-inflation relationship is looser than in the past, slack itself its narrowing, strong global growth is pushing up commodity and import prices, and some measures of inflation expectations are rising.  As a result, our inflation views are unchanged: We expect core inflation to decline towards 1% over the next several months, but to rise back to 2% in 2011. 

Three sources of uncertainty.  There's broad agreement that inflation and pricing power diminish as slack in the economy rises.  Yet there's still uncertainty around three issues:

•1.      Inflation measurement: Measures of ‘core' inflation are diverging.

•2.      Modeling the key inflation determinants: There is uncertainty over how to measure both inflation expectations and slack in the economy, and how to gauge their relationships with inflation. 

•3.      How the Fed's response will shape the outlook: Many officials take comfort from today's relatively well-anchored inflation expectations.  But today's well-behaved readings could change if investors believe that the Fed - for whatever reason - has overstayed its welcome. 

Measurement uncertainty.  There is, to start, uncertainty over the ‘right' measure of underlying or core inflation (see Will the Real Core Inflation Measure Please Stand Up? July 7, 2006).  The two popular measures of core inflation diverged over 2009: Measured by the CPI, core inflation was stable, but it declined by 30bp measured by the personal consumption price index (PCEPI).  While the differences mainly result from different ways of measuring some prices, they may create uncertainty over the direction of inflation.

Model uncertainty.  There's even less certainty about key inflation determinants and the model that links them to inflation.  Over the 30 years since the Fed held a first conference on inflation modeling, the workhorse ‘markup over cost' model has proven increasingly less reliable, courtesy of good monetary policy, globalization, and changes in firm pricing behavior.  Indeed, our analysis suggests that firms now price ‘to market', setting prices based on conditions of demand and supply in global product markets, rather than marking up over costs (see Inflation Model Uncertainty, June 2, 2005). 

Both models do include three key elements, however: A measure of inflation expectations, a gauge of slack in the economy, and factors that ‘pass through' to underlying inflation, like changes in energy or import prices.  But it appears that the slack-inflation relationship has loosened over the past several years, and that the pass-through has also diminished.  The flattening of the so-called ‘Phillips curve' may mean that as slack increases, inflation may not fall as much today as it did in the past.  The price-to-market model may also help explain this phenomenon, as companies absorb costs, including currency swings, more readily into margins.

The Fed's role.  Thanks to a long period of effective monetary policy, lower and more stable inflation expectations may have shifted the slack-inflation relationship down, rather than altered its slope, so that empirical analysis must consider all these factors.  Indeed, studies show that inflation expectations will influence inflation, and in turn, that monetary policy anchors expectations.  The pricing dynamics of such models are consistent with our price-to-market hypothesis.  But uncertainty regarding the Fed's future course risks weakening the anchoring effect, as discussed below.

How much slack is there really? Our inability to measure economic slack and inflation expectations with any precision also adds to inflation uncertainty.  Measures of slack, like the output gap, are unobserved, and the unemployment rate only measures slack in labor markets, not in product markets.  Fed Vice-Chairman Kohn recalled a few years ago that "faulty estimates of potential output may have contributed to the monetary policy errors of the 1970s".  That may be relevant today: Some fear that the financial crisis has depressed potential growth by as much as 1 percentage point to 2%, heightening the upside risks to inflation.  In our view, it has declined, but only slightly to about 2.5%, with scant implications for inflation. 

We think the Phillips curve has flattened.  The upshot is that significant increases in economic slack - measured by the doubling of the unemployment rate or by the plunge in operating rates - over the past two years will depress, but are unlikely to crush, inflation.  The good news is that the Fed's strenuous efforts to limit deflation risks have kept inflation expectations from falling.  The main downside risk for inflation now comes from a further deceleration in rents.  Slack in housing markets has sharply depressed the increases in both tenants' rent and owners' equivalent rent, which account for one-third of the core CPI and about one-sixth of the core PCEPI.  We think the downside risk to rents is limited now that the bust in housing activity (and thus supply) and stabilizing demand are combining to promote a peak in housing-market slack.

Pushing inflation higher: Speed effects, global growth and breakevens.  Moreover, we believe that three factors are pushing inflation higher: Slack is narrowing, and inflation responds to changes in slack as well as to the level; strong global growth is pushing up import quotes; and inflation expectations are either stable or higher, suggesting little risk of substantial disinflation. 

The idea that ‘speed effects' - or changes in slack - as well as the level affect inflation is controversial and difficult to pin down empirically, although it makes intuitive sense.  The notion is that a trough in operating rates or a peak in the jobless rate will trigger a change in direction in businesses' and consumers' outlook for the factors that drive inflation.  It may be reinforced by the fact that cyclically sensitive prices, like those for food and energy or other commodities, will rise in recovery.  Consequently, such effects are strongest for wholesale or producer prices, but in turn we believe that they matter for consumer prices as well.

More important, several global factors seem likely to contribute to US inflation over the next few months.  Among them: Strong global demand and limits on supply are boosting energy and food quotes.  Energy quotes jumped at a 25.6% annual clip in the three months ended in December.  While the pace should slow from here, our commodity team believes that the direction is higher.  Measured in the CPI, meanwhile, US retail food prices have also accelerated - admittedly to a modest 1.3% annual rate in the September-December span.  But the strength of global demand is likely to push food prices higher.  Finally, US import prices are beginning to turn up again.  We believe that sellers typically pass some of these price hikes through to core prices with roughly a 2-4-month lag.  Together with the lagged effects of a weaker dollar, these price hikes may also contribute to US inflation by reviving inflation expectations.

Inflation expectations are already edging higher.  Measured by 5-year, 5-year inflation breakevens, inflation expectations have moved up to 2.75-3%.  And survey-based measures are also edging up; in late January, median long-term inflation expectations in the University of Michigan canvass inched up to 2.9%, and year-ahead inflation expectations rose to 2.8%.  To be sure, such surveys are volatile and may be unreliable, as they are based on small samples, do not refer to any specific index, and encompass a wide dispersion of views across households.  But directionally they are important to watch.

Fed to change inflation outlook at mid-year.  These cross-currents will net to lower inflation for now.  But by mid-year, we think investors' and the Fed's outlook for inflation will change as the forces pushing inflation higher gain the upper hand. 

At that point, the Fed's role will be critical in shaping inflation expectations.  Market participants already are concerned about Fed credibility, given the unprecedented monetary stimulus in place.  They cite two related factors: First, and most important, they fret that officials won't have the mettle to tighten or will be constrained by politics from tightening appropriately.  Alternatively, some believe that the Fed will simply make a policy mistake and overstay their welcome.  Against this backdrop, policymakers must be prepared to prevent inflation expectations from rising excessively, and we think they will. 

Indeed, that is a cornerstone of our Fed call: We think that the change in the inflation outlook will prompt the Fed to begin exiting from zero rates during the second half.  In the meantime, with a set of global factors potentially pushing up inflation expectations, lingering questions about the Fed may translate into market uncertainty, pushing up term premiums and steepening the yield curve.

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