Forecast Upgrade: Upside for Economy, Deflation Dragging On but Over the Worst
April 09, 2010
By Takehiro Sato & Takeshi Yamaguchi l Tokyo|
Exports to Asia Continue to Boom, Spreading Recovery in Private Domestic Demand Too
The March Tankan indicated that the manufacturing sector recovery, fed by vibrant exports to Asia, is gradually spilling over to private-sector demand. Exports to Asia did not drop back after the Chinese New Year, and manufacturing performance in Jan-Mar was up about 4%Q, maintaining almost the same momentum as in Oct-Dec.
Domestic demand categories that have struggled to date are also now showing firmer- than-expected performance. The undertone of personal consumption, chiefly in durable goods, is surprisingly resilient to downside shocks from steep falls in nominal wages and income, thanks to policy measures and pent-up demand. For the same reasons, we expect residential investment to have moved to a sequential recovery in Jan-Mar. The second preliminary GDP for Oct-Dec has already confirmed recovery in capex, and we expect a moderate recovery trend for Jan-Mar as well. Therefore, we see potential for Jan-Mar real GDP to rise at an annualized rate of close to 3.6%, well above our previous outlook of 1.3% as of March 11.
If so, this provides a base effect for F3/11 of 1.3pp and sets the scene for real growth of 2.7% (2.5% for F3/11). For 2011, on the other hand, we have already been taking a slightly more guarded view than for 2010 globally, given signs that leading countries are working towards macro policy exit and that additional stimulus for Japan's economy from fiscal measures can no longer be expected. There are no compelling reasons to change our outlook significantly now, so our overall view for 2011 is largely as before. However, as discussed later, we lift our price forecast by 0.2pp due to a reaction to the scrapping of high school tuition fees in F3/11.
Upside in Personal Consumption
Near-term risks for Japan's economy come from upside for external demand and personal consumption. After all, personal consumption has not collapsed despite historic wage declines, in fact holding up relatively well. This has been obviously attributed to government support measures - eco points, tax incentives for replacement car purchases, etc. - mainly affecting durable goods consumption, but we think another important factor is that households are tired of extreme penny pinching. Also evident during the financial crisis of 1997-98, households tend to start loosening purse strings generally about one year on from the crisis phase. Back then, consumption plummeted after the financial crisis of November 1997, and then picked up from Oct-Dec 1998, chiefly in durables like household white goods and compact passenger cars. The then chief of the Economic Planning Agency, Taichi Sakaiya, referred to this as ‘symptoms of change'. The current situation has similarities in that consumption recovery has begun with durable goods. Whether consumption recovery based on durable goods will spill over into non-durables is an open question, however. It is hard to say that non-durables consumption picked up sustainably in the recovery from end-1998 to 1999, for example.
For this consumption recovery based on durable goods to give way to broader and more sustainable recovery will require support from recovery in wages and income, which we think is still some way off. Marked wage recovery cannot come about without a recovery in bonuses, and since companies pay bonuses on the basis of results in the previous business year, and most decide on lump-sum bonuses for summer and winter, there seems little prospect of pronounced recovery in bonuses, and hence wages, in 2010. We believe the more probable scenario is for wages to start recovering noticeably from summer 2011 bonuses in response to further improvement in corporate earnings in F3/11, and until then, growth in overtime wages just barely pushing wages upward in year-on-year terms.
Yet this does not mean that there is nothing to tide over until wage recovery. The new child care allowance from June should help as support from cash handouts in the previous year wears off. Further, though by no means certain, it is possible that this summer could be a hot one, following the comparatively cool summer of 2009, which could boost consumption of summer goods. There is an observed tendency, for example, for average temperatures to be lower than normal in July of a year following a July which saw higher than average temperatures. Hence, it is possible that domestic demand, and above all consumer spending, will maintain a firm undertone even without a noticeable recovery in wages.
Deflation Becoming Protracted but over the Worst in Terms of Year-on-Year Comparison
Prices can also show subtle changes of tone amid a trend of deflation. Based on the current output gap, underlying prices excluding fresh foods/energy and various systemic factors could continue falling year on year for the next 3-4 years. This outlook may well be disappointing for investors, but from the perspective of investment, we think the key to watch is the timing of narrowing in year-on-year declines.
The core CPI excluding fresh food prices (Japan-style core) bottomed year on year with a fall of over 2% in summer 2009, but a clear sense of recovery in prices has yet to emerge. This is because the improvement in the Japan-style core owed mainly to rebounding energy prices in 2009. In fact, the US-style core excluding food and energy has maintained a slide of historic proportions in 2010 as well.
However, it is possible that underlying prices (which exclude all systemic factors) bottomed at around -1.4%Y in December. The scrapping of high school tuition fees from April is likely to cause the rate of deflation in the Japan-style and the US-style core CPI to expand again. Yet we think underlying prices and the 10% trimmed-mean estimator are likely to show narrowing rates of decline year on year, despite these systemic influences.
The micro data too appear to show that retail prices such as foods and clothing are heading toward stability as of February, following discount sales in December/January. In macro terms a time-lag of about three quarters is observable between the output gap and underlying prices, but since the output gap has been improving from around -8% in Jan-Mar 2009, this is generally consistent with the current improvement in the rate of price decline.
The start of a narrowing year-on-year fall in prices does not in itself sound the end of deflation. However, we think emerging signs of a brake on such prolonged deflation will be of much interest to market participants who place considerable emphasis on changes in momentum. Given such an outlook for the economy and prices, we see the market's excessive pessimism retreating ahead.
Meanwhile, medium- and longer-term concerns should linger in the foreseeable future. Our estimates suggest that medium-term inflation expectations may already have dropped into negative territory. The downward shift in medium-term inflation expectations is a risk that could prompt households and companies to further delay investment and consumption activity until well into the future, resulting in a further demand slump, improvement in the output gap is likely to be slow, and ultimately, deflation is likely to worsen further. Indeed, based on our estimates, the medium/longer-term inflation expectations have been slightly negative since Oct-Dec 2009.
Monetary Policy Is Still in a Cycle of Easing
An early exit from deflation is not in prospect even with upside for the economy, and we expect the government to continue to lean on the BoJ for monetary easing, with an eye on the upper house election in July. We think the BoJ is likely to adopt a conciliatory approach too. The specific menu of easing options that we envisage, in order of likelihood, is outlined below. Of these, we think (1) and (2) could be triggered in the Apr-Jun quarter, specifically at the time of or after the release of the Outlook Report on April 30, and that (3) would be likely in the Jul-Sep quarter, particularly when the ‘Medium-Term Fiscal Framework' comes out in June.
(1) Extending the value or duration of fixed-rate funding operations: An extension from ¥20 to ¥30 trillion, or from 3 months to 6 months. Move to guide term interest rates lower, aiming to lower benchmark interest rates such as Tibor and Libor.
(2) Introduction of inflation targeting, clearer commitment to policy duration: A move to upgrade to a policy target of ‘an understanding of price stability over the medium and long term'. If the government and BoJ have a common price target, monetary policy and currency policy (favoring a weaker yen) would be promising tools for achieving it. But if the government refrains from committing to a price target, policy effectiveness would be diluted as monetary policy would be the only means to this end. The policy implications are yield curve steepening in the former case, and flattening in the latter case.
(3) Increasing JGB purchases: The BoJ is currently negative on this, given the terms of the Public Finance Act. But if the government's Medium-Term Fiscal Framework for management of public finances in June includes credible targets for balancing the public books, the BoJ could act from the standpoint of support for fiscal rebuilding and increase purchase amounts. Even if the decision is taken that right before an election is not the right time to include this in the Medium-Term Fiscal Framework, the BoJ could act to buy more JGBs in a show of support for the government's efforts at fiscal reconstruction.
(4) Rate cut: A cut from 10bp to 5bp. We think this would be the most effective means of unwinding the reversal of dollar Libor and yen Libor rates and addressing the high level of Tibor. FX rate disturbance would make this more likely. However, actually, the recent bias towards a weaker yen reduces the probability of this measure.
Short-Term Rates Hinge on FX Levels
As above, the outlook for short-term interest rates depends a lot on the FX rates. In the event that the yen strengthens sharply in reaction to adverse effects on global asset markets from emergence of sovereign risks in Europe, revaluation of the renminbi, and absorption of surplus liquidity when policy is exited, the probability of a rate cut would rise. If these risks do not emerge, however, Japan's economy could overshoot the BoJ's forecasts as well as our own, and eliminate the possibility of a rate cut.
Meanwhile, we maintain our outlook for a policy exit in Japan in Jan-Mar 2012.
In its interim assessment of last October's Outlook Report in January, the BoJ raised its forecast for the core CPI in F3/12 to -0.2%Y (from -0.4% previously). We think it may also raise its price forecast for F3/12 in the coming Outlook Report in April 30, reflecting an improved growth rate, changes in the price outlook for imported commodities such as crude oil, and systemic factors such as fading of the impact of ending high school tuition fees and hiking cigarette tax.
Since the BoJ has a track record, from when it ended quantitative easing in 2006, of justifying a rate hike by price inflation that stemmed from higher commodity prices, the Outlook Report could strengthen speculation that the BoJ will seek to move towards the exit on the basis of the timing of a positive turn for prices. The key market implication is that a tacit commitment to monetary policy duration is not likely to be extended further.
Long-term rates are now moving in line with the global trend toward equity strength and high long-term yields, and we think the bond markets in the near term in April and May will be fairly weak. We think the 10-year yield in that period could have an upside to about 1.50%, wary of possible bear positions from overseas investors before the Medium-Term Fiscal Framework appears. But we maintain a bullish stance on the bond market for the period after the framework is announced in June, seeing potential for additional quantitative easing based on a drop in the expected rate of inflation for the medium term. We see room for a drop to 1.25% for the 10-year by the end of June.
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On Different Sides of ‘Neutral'
April 09, 2010
By Manoj Pradhan l London & Gerard Minack l Sydney|
The RBA hiked its policy rate on April 6 for the fifth time in six meetings. In contrast, the RBNZ struck a dovish tone in its monetary policy statements. Investors have tended to paint both economies with the same brush. They share many characteristics, but their experiences during the Great Recession were very different. While Australia avoided a recession thanks to its aggressive policy stimulus, the New Zealand economy contracted for five consecutive quarters starting in 1Q08. Consequently, their central banks have chalked out very different exit strategies. On one hand, we estimate that the RBA policy rate is already at neutral, and the 1-2 further hikes we see for the rest of the year will push monetary policy into slightly restrictive territory. On the other hand, the RBNZ will keep its policy rate below neutral this year and is likely to move towards neutral only some time next year.
Australia and New Zealand have seen their trading partners race out of the global recession, and improving terms of trade could amplify the benefits for both economies. Both have benefitted from very low interest rates and expansionary fiscal policy and both face the prospect of dwindling stimulus as rate cuts are unwound and fiscal consolidation starts.
But there are considerable differences between the two, notably on inflation. Core inflation in Australia is uncomfortably high, one factor behind our forecast for the cash rate to be pushed into slightly restrictive territory. We think that another 1-2 increases will be sufficient, in part because we expect weaker consumer growth due to domestic factors, in part because we have a below-consensus estimate of the neutral policy rate. In New Zealand, inflation is likely to be much better behaved. The RBNZ will therefore pay more attention to ensuring that the fledgling recovery is entrenched. The ‘neutral' real rate of interest has likely fallen in New Zealand as well, suggesting that fewer hikes are required to take interest rates into neutral territory.
The vastly different exit strategies of these two neighbouring and interlinked economies have interesting implications for other G10 economies. The US has a reasonable growth trajectory in place and inflation is expected to pick up only slowly according to our economics team. In the UK and the euro area, however, there are still significant headwinds to growth but inflation is already tugging at the reins. It is likely that the exit strategies there will fall somewhere between those of the central banks down under.
Even with a strong recovery, the RBA will likely be constrained when it comes to raising rates, given that neutral rates themselves are lower. The RBNZ will also have an eye on its own neutral rate when it comes to raising rates since it will not want to push rates to neutral territory too quickly. When it comes to fighting inflation, the RBA has been able to push rates higher quickly because of the strong economic backdrop. With consumer growth expected to moderate, it will be interesting to see whether it can stay committed to aggressive tightening of monetary policy. For the moment, it is likely that both the RBA and the RBNZ will aim to be on different sides of ‘neutral'.
Australia: On its Way to a Restrictive Stance
The Reserve Bank faces a difficult balancing act. On the one hand, it seems clear that Australia will see a renewed surge of resource-centred growth: both higher terms of trade (export prices relative to import prices) and resurgent mining-related investment spending. On the other hand, the massive policy stimulus from the past 18 months is fading, and there is good reason to think that the ‘neutral' cash rate level is lower than it has been. On balance, we think that the RBA will have to tighten 1-2 more times this year.
The mining boom faced a serious setback in 2009. Certainly, we do not think that ‘China saved Australia' from the global recession. Australia's mining exports fell by 38% through 2009. Overall exports fell by 25%. The prior worst-ever four-quarter decline was 15% way back in 1960. However, the quick recovery in Asian growth, and ongoing supply blockages, point to resurgent export prices and mining-related investment spending.
We illustrate Australia's real GDP and national income growth. The latter adjusts GDP for the real income effects of changing terms of trade. The fall in national income in this cycle almost matched that in the 1990s recession. However, the terms of trade are set to rebound smartly this year due to the higher price of bulk commodity export prices. The prospect is for national income to return to high single-digit percentage growth heading into next year.
In addition to the terms of trade effect, the already-bulging investment pipeline is about to see another surge. Miners expect to increase investment spending to over A$60 billion in F2011. We illustrate the unprecedented surge in non-residential investment seen over the past decade.
All this argues for the RBA quickly returning policy to a restrictive setting, given the already-low unemployment rate and relatively high CPI (the average of the RBA's two ‘core' CPI measures was at 3.4% over the year to December quarter 2009).
However, there are two important offsetting considerations. First, the massive domestic policy stimulus - which I think was the key to Australia avoiding recession - is reversing.
The growth in disposable household income has peaked at 12% early in 2009, largely due to policy effects (lower interest rates and fiscal handouts). Labour income fell almost as far in the last year as in the last recession. (More evidence, as an aside, that China did not ‘save' Australia.)
The policy stimulus is now reversing. Consequently, we expect that household income will stagnate this year, despite stronger labour income.
The RBA also has to take into account two factors suggesting that the ‘neutral' cash rate is now lower than it has been historically. First, household debt is significantly higher relative to household income. Most household debt is mortgage debt, and most mortgage debt is floating-rate (tied to short-end interest rates). Higher debt means that any given change in effective interest rate has a bigger impact on household income. Second, the spread between the mortgage rate and the cash rate target has widened, thereby amplifying the impact of cash rate hikes felt by households who pay the mortgage rate, not the cash rate. We estimate that this spread has widened by around 200bp since mid-2005.
Adding the long-run average real cash rate target (3.25%) and the inflation target of 2.5% puts the simple measure of the ‘neutral' cash rate at 5.5-6%. In fact, we think that neutral cash is probably around 4-4.5%. The current cash rate is now 4.25%, so the RBA is almost at neutral, in our view. Another 1-2 25bp increases this year would put the target into the (marginally) restrictive zone - hence our forecast for that increase this year.
Domestic factors will drive policy: We think that the two key drivers of policy this year - the risk factors that could push rates higher than we are now forecasting - are both domestic. The first is employment. The peak for unemployment in this cycle was not far from the trough seen in prior cycles. The Australian labour market is likely to hit pinch points in selected areas if employment growth doesn't moderate soon.
The second driver is house prices. The RBA has for some time, sotto voce, been concerned about Australia's elevated house prices. Now it is signaling its concerns loud and clear. If house prices continue to rise at their recent pace - double-digit gains in the capital cities - expect the RBA to push rates quickly into the restrictive zone.
New Zealand: On the Other Side of Neutral
The situation is far more clear-cut for the RBNZ, and the slow and steady path it is taking towards raising policy rates is likely to continue even after it starts hiking rates.
The New Zealand economy is again growing after a long recession, but the sustainability of that recovery is far from assured. The inflation profile is fairly benign and unlikely to worry the RBNZ. Finally, markets have jumped the gun quite a few times already in trying to anticipate a start to rate hikes, which has helped the RBNZ by allowing it to have higher front-end rates without even raising the Official Cash Rate (OCR). We hold our long-standing call for the first rate hike to arrive at the July meeting, with four rate hikes (possibly three) of 25bp this year, depending on the response of the economy to the hikes.
Spot the difference: The difference in the policy rates in Australia and New Zealand could arguably be justified by looking at one simple comparison: the relative economic performance during the Great Recession. While the Australian economy avoided recession and surprised everyone by showing robust employment throughout the Great Recession, the New Zealand economy shrank for five consecutive quarters and began growing only in 2Q09.
The growth picture remains quite mixed: In the case of New Zealand, this is true almost too literally. Going by the 4Q09 GDP report, only four of eleven industry groups had recuperated all the output lost since the peaks in 2007. However, the four groups (including the heavyweight Finance, Insurance and Business Services industry which accounted for nearly 29% of GDP) make up nearly half of GDP in New Zealand.
Some upside risks... Like Australia, New Zealand stands to benefit from favourable terms of trade as well as the improved global (and particularly Australian and Asian) growth outlook. The top three destinations for New Zealand's exports - Australia (23% of exports), China (10%) and the US (9%) - have all shown better-than-expected growth and the booming Asia ex-Japan region accounts for a whopping 27% of New Zealand's exports according to February 2010 data.
...but downside risks dominate: Risks to the downside, however, are still evident from the 4Q09 GDP report. While house prices have rebounded smartly, household loan activity has been positive but flat at around the same level as 2009. Consumer loans, on the other hand, are still negative and not far off their lows. This is not surprising, considering that full-time employment is still weak and has a way to go before it can catch up with the 2007 level. And the weak labour market also reflects weak investment spending on fixed assets. How much of the higher private consumption spending and the resumption of residential investment can be sustained without a policy stimulus will obviously be something that the RBNZ will pay a considerable amount of attention to.
What of inflation and rates? If the growth picture shows considerable reason for the RBNZ to prefer a slow exit, the inflation outlook and a lower level for the ‘neutral' rate only serve to make this strategy an optimal one.
CPI versus GDP deflator: In its last policy statement, dated March 11, the RBNZ explicitly conveyed to markets its willingness to look through near-term rises in the CPI measure (which it believes will be due to technical factors). The 4Q09 reading for the GDP deflator showed flat prices on a year-on-year basis for New Zealand's output even as the basket of consumer goods ticked up to nearly 2%Y. This will give the RBNZ further conviction in its decision to raise rates slowly, in our view.
Lower ‘neutral': And finally, the ‘neutral' rate and twitchy markets have also helped the RBNZ to keep the OCR low. Given the recession in the NZ economy, we believe that both potential output and its companion, the ‘neutral' real rate of interest, have fallen. We estimate that the neutral real rate of interest is around 2-2.5% - at least 1% lower than it is likely to have been prior to the global recession. Thus, much like the RBA, which likely already has a neutral policy stance, the RBNZ will not have very far to go before it takes away monetary policy accommodation. It must therefore raise rates with caution. And markets have helped. By attributing the same policy rate profile to both Australia and New Zealand, markets have pushed up front-end rates. This has ironically worked in the favour of the RBNZ as it has benefitted from higher front-end rates without actually raising its Official Cash Rate.
Of course, there are risks that the RBNZ may not always be as frugal in its withdrawal of policy stimulus. For one thing, a lower neutral rate also means lower potential output and a smaller output gap. This takes away some of the sand in the inflation mechanism. For another, the bigger risk in the world economy is that of upside surprises to growth. If the New Zealand economy benefits a lot from global growth, the RBNZ may just have to raise rates faster. Despite these risks, we think that the domestic scenario we have painted will allow the RBNZ to stay on the other side of neutral from its neighbour.
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