Brazil
Step by Step
April 20, 2010

By Marcelo Carvalho | Sao Paulo

While most analysts are concentrating on whether the Copom starts with a hike of 50bp or 75bp, the real issue is whether the central bank will have to conduct a much larger (and longer) hiking cycle. Rate hikes are clearly underway, with a monetary tightening cycle expected to start on April 28, after a split vote to stay on hold at the latest Copom meeting in March. But the central bank does not seem eager at this stage to front-load its monetary tightening cycle with aggressive moves. Instead, it seems to prefer a more measured approach, going step by step for now, and leaving open the option of catching up later on, if necessary. Still, with recent activity data surprising to the upside, the risk is growing that rising concerns about overheating could end up forcing the hand of the central bank to turn more aggressive - perhaps hiking more and for longer than it may have planned at first.

Rate Hikes - Front-Loaded or Spread Out?

It is virtually certain that the Copom will hike interest rates on April 28, as the central bank has clearly signaled through its various communication channels, including recent Copom minutes and the latest quarterly inflation report. After all, inflation is picking up, and inflation expectations are rising away from the target, amid strong domestic demand and signs of shrinking slack in the economy.

The inflation picture is worsening. This is true for headline consumer price inflation, as well as for measures of core inflation. Annual IPCA inflation has climbed to 5.2% in February 2010, from a low of 4.2% last October. And all three main measures of core inflation that the central bank monitors closely have turned up as well. Likewise, inflation expectations are rising too. Not only have inflation expectations for 2010 now exceeded the 5.0% mark, but expectations have also increased away from the 4.5% target for 12-month-ahead inflation and for the calendar year 2011. 

There is a significant historical correlation between inflation expectations and policy interest rate decisions in Brazil. In a sense, 12-month-ahead inflation expectations are still "under control" at the moment - while above the 4.5% target center, they remain below 5.0%, and are safely below the target ceiling of 6.5%, considering the official tolerance band of two percentage points around the target center of 4.5%. However, inflation trends do not look encouraging. We believe that the central bank will need to hike rates as much as necessary to guide inflation expectations back towards the target. Also, the central bank needs to make sure it communicates its reasoning clearly to market participants.

Effective policy communication is crucial for monetary policy success. Unfortunately, the March Copom minutes left many observers confused. The minutes clearly laid out the arguments for a rate hike, but failed to explain why the Copom instead decided to stay on hold. The contradiction was later clarified in the subsequent quarterly inflation report, which explained that the Copom decided to wait until April in order to monitor the impact of a previous hike in reserve requirements, as well as the unwinding of some previous fiscal stimulus measures, such as tax breaks on automobiles and white-line goods.

While the Copom is more than ready to hike, it seems unwilling to surprise markets with a big shock. The authorities appear to offer five main arguments in support of staying cool and following a more commensurate approach:

First, the economy is heating, but not yet overheating - the argument goes. The reasoning is that, on recent trends, the economy would surely overheat if the authorities did not act. But they will act. The central bank seems convinced that, in 9-12 months from now, inflation expectations will be back to the 4.5% target, in response to upcoming policy action.

Second, resource utilization is not uniformly tight. Tightness is clearest in labor markets. The unemployment rate has fallen to record lows, and recent net formal job creation is expanding strongly, now firmly back to pre-crisis record-high standards. In fact, job creation during 1Q10 was the best on record. However, although climbing, capacity utilization in industry has not yet returned to pre-crisis peak levels, according to data from Fundação Getulio Vargas (FGV) or from the national industrial association (CNI). One interpretation is that previous investments are now maturing and help expand industrial capacity, even though there is little question that fast demand growth is outpacing supply expansion.

Third, it should not take aggressive tightening to bring inflation back to target, according to central bank models. Under the so-called "market scenario", IPCA inflation would finish 2010 at 5.2%, but would then slow down to 4.4% (slightly below target) by end-2011, according to central bank simulations shown in the latest quarterly inflation report. The market scenario assumes the consensus view about the currency and rates among market analysts, as surveyed by the central bank. Namely, this scenario assumes a relatively stable exchange rate and a hiking cycle by end-2010 of 250bp, which is less that the yield curve's pricing of hikes totaling about 350bp this year.

Fourth, go step by step. Although it may have a rough initial idea about how the hiking path could look like, the Copom does not know in advance the exact size of the full cycle. In that context, the authorities seem inclined to go step by step and adjust the process according to evolving macroeconomic conditions, such as growth and inflation. It is interesting that the quarterly inflation report removed a statement previously introduced in the March Copom minutes. The minutes had underscored that, while the Copom stayed on hold in March, the size of upcoming hikes could be adjusted according to circumstances. It seems the authorities subsequently feared that such statement might be incorrectly read as a commitment to a larger hike in April than the 50bp hike that was initially contemplated in March. The question for the Copom in March was about timing, not pace. The question was whether it could wait 45 days to start the hiking cycle or not. The majority of board members concluded the answer was ‘yes'. In all, in our view, the message here is that a delay in hiking does not necessarily mean that the Copom must start with a bang in April.

Fifth, there are also benefits in spreading the cycle over time, as opposed to front-loading it. There is a trade-off: a front-loaded strategy gets a bigger initial impact, but a gradual approach has a more lasting effect. It is a tricky balance. If the Copom front-loads the hiking cycle with a shock, which markets seem to favor now, then there is a large initial impact on expectations, and the cycle can arguably end sooner. But after an initial shock on expectations, the impulse for recovery then resumes sooner than otherwise, once the perception consolidates that the central bank is done. In other words, it would seem that the economy responds not just to the level of rates but also to its change. The reasoning here is that keeping the tightening cycle going for as long as possible helps keep sentiment in contraction mood for longer. In other words, there is a trade-off between using all rate hike ammunition quickly and spreading it out over time.

In all, the Copom seems to judge that it can always catch up later, if necessary. Indeed, in the last two tightening cycles under the current administration (2004-05 and 2008), the central bank started with a moderate move and then sped up the hiking pace later on. In 2004, the central bank started the tightening cycle with an initial 25bp hike in September 2004, but then accelerated the pace to 50bp in October, a pace which it then maintained in the following months. In 2008, the Copom started to hike with a 50bp move in April, and repeated the pace once again in June, before speeding it up to 75bp in subsequent meetings.

Start with a starter? We continue to forecast that the Copom will start the upcoming tightening cycle with a 50bp hike on April 28, even though a 75bp move cannot be ruled out. Unlike March's split vote to stay on hold, a formally unanimous decision to hike in April would be instrumental to show internal cohesion and help fight the inevitable external criticism that monetary tightening normally entails.

Looking further ahead, the Copom may well prefer to take a breather after hiking for a few months, in order to take stock of the situation and then decide whether to proceed with further hikes or not. In fact, our forecast assumes that the Copom will interrupt its hiking campaign with a pause during the October presidential elections. The main risk to the game plan is that strong domestic demand and worries about overheating end up forcing the hand of the central bank to take a more aggressive stance.

Indeed, the economy is growing fast. Real 4Q09 GDP grew 2.0%Q, seasonally adjusted, but not annualized. This sequential expansion means an annualized pace of 8.4%. While there is much debate about Brazil's potential real GDP growth, there is no question that the recent pace is above potential. And recent data releases so far in 2010 have surprised to the upside, suggesting that the economy may have grown at a similar sequential pace in 1Q10 to that seen in the last quarter of 2009, which adds upside risks to our 5.8% real GDP growth forecast for 2010.

For instance, industrial production was strong and better than expected in February, climbing 1.5%M, on top of a sequential expansion of 1.2% in January, and boosting the annual comparison to 18.4%. Put another way, industrial production on average during the three months through February has grown sequentially at an annualized pace of 10.9%. After a plunge in late 2008, industrial production has expanded steadily since early 2009. Partial data for March suggest yet another strong monthly figure, judging by proxies like paperboard sales, automobile output and heavy traffic in main roads.

Likewise, retail sales numbers are solid. Retail sales outpaced market expectations in February again, jumping 1.6%M, after a record gain of 3.0% in January. The annual comparison improved to 12.3%, helped by easier credit conditions, increasing consumer confidence and improving labor market conditions. While the expansion is broadly based, sales of durable goods suffered the most in the late 2008 downturn, but have since recovered the fastest. Here too, partial data suggest another positive reading in March.

Bottom Line

While many observers focus on the size of the upcoming initial rate hike, the real issue is whether the Copom will be forced to conduct a more aggressive cycle than it initially planned. The Copom does not seem eager to shock markets with a front-loaded bang. Instead, it sounds inclined to go step-by-step, adjusting along the way. That said, the risk is rising that upward growth surprises and rising inflation expectations might force the hand of the central bank to take a firmer stance, having to hike more and for longer than it initially envisaged.

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Hungary
Hungary Trip Notes
April 20, 2010

By Pasquale Diana & Chuan Lim | London

We visited Budapest on April 13-14 and had meetings with a political analyst, a local economist, a local bank, the National Bank of Hungary and the AKK (Debt Management Agency). Please find our conclusions below. Feel free to call for more color.

Fidesz set to achieve its two-thirds majority. Most observers think that Fidesz will get its two-thirds majority. Even if it should be a few votes short, it should not be a major issue to gather enough votes in parliament. The ‘supermajority' would allow Fidesz to adopt sweeping structural reform, for example suppress part of the 3,200 local governments to save money, amend the media law, grant citizenships to Hungarians living abroad (this may raise tensions with neighbouring countries). Support for far-right xenophobic Jobbik at 17% looks high (particularly among young people), but besides the odd negative headline that will raise eyebrows in the international press, there will be no consequences on policy or governance. With the Socialist party in disarray and an electorate hungry for change after eight years of Socialist rule, Fidesz could establish a very solid and long-lasting hold on power.

What is the true fiscal picture? Lots of question marks remain. By far the issue which we found the most controversy around was the fiscal deficit picture after Fidesz gets into office (June-July) and implements a fiscal audit. We found broad-based confirmation of our view that Fidesz understands the importance of the IMF framework. For that reason, any upside revision to this year's deficit target (3.8% of GDP) will be the outcome of a negotiation with the Fund. Essentially, Fidesz will deliver reform plans in return for a deficit target which is less detrimental to the growth outlook. This is very different from outright fiscal easing.

Therefore, later this year there is a high probability that Fidesz chooses to revise the deficit target up to around 5% of GDP. This does not include the possible inclusion of extra-budgetary items, such as the debt of the Budapest Transport Company (BKV), the railway company (MAV) and the debt of local governments. These, the NBH estimates, could add another 1.5% to the deficit. They would of course be a one-off, even if all paid in 2010, but they may not affect issuance at all, as the Min Fin could simply pay off this debt out of its cash pile, according to the AKK.

All in all, there is not a great deal of clarity. While we think that a revised 5% of GDP target (with IMF approval) would not rock sentiment, we also heard more bearish views. These argue that the budget for 2010 and the spending allocations to some key areas (such as healthcare) are unrealistically low, and Fidesz will put an end to underfunding of hospitals, accept a higher deficit in the short term and implement sweeping expenditure reform for the coming years. Senior economists close to Fidesz envision a ‘Slovak-style' adjustment that will bring revenue to GDP (now the highest in the region) down by 10pp, in line with the rest of the region. Of course, this would imply radical suppression of local governments, unproductive state agencies and whitening of the underground economy. This ‘shock therapy' may eventually yield great results, but we think that the market's initial reaction to a much wider deficit in 2010 (7% of GDP was mentioned as a possibility, ex one-offs) would be definitely negative.

Rates headed lower, as NBH set to continue to exploit favourable conditions to ease. The meetings we held at the NBH had far more clear-cut conclusions. The bank remains firmly in easing mode: its modus operandi is the following: the CPI and GDP outlook still suggest cuts ahead. These will be delivered (at least 50bp more in our base case, to 5%) as long as the risk environment is supportive. The central bank's assessment of risk is, in the words of a policymaker, "more an art than a science". A number of metrics are monitored, including CDS spreads, the currency, liquidity indicators, banks' funding conditions and bond yields. The NBH believes that the recent news on Greece, which has avoided a near-term liquidity crisis, represented a concrete step which lessened the risk of contagion to CEE. Logically, it follows that failure to disburse aid to Greece should Greece request it would have a material adverse impact on the NBH's risk assessment. We detected some frustration at the fact that, despite the undeniable improvements in fundamentals, markets remain rather sceptical and still tend to put Hungary with the ‘weak' credits.

NBH is not swimming against the tide. The NBH is unfazed by the fact that some EM central banks have started increasing rates, and does not at all feel that it is ‘swimming against the tide'. The central banks that matter to the NBH are its regional neighbours (CNB, NBP) and the ECB. None of these banks appears in any way in a rush to tighten policy. On the contrary, the NBH stressed how some on the CNB are considering more cuts, and that the NBP is busy stemming PLN gains, rather than considering rate increases.

CPI outlook benign, unshakeable faith in the output gap. No HUF gains needed. The bank noted with some surprise that the higher-than-expected March CPI had been wrongly interpreted by some commentators, and that the underlying structure is benign (we agree). Particular attention is paid to services components (market services in particular), as indicative of the ‘true' demand-sensitive CPI trends. Also, the bank notes that the growth in services wages, another valuable indicator of inflation expectations, has slowed dramatically. We remain sceptical on the extent of the disinflation the bank sees in 2011, and believe that ultimately the NBH will be disappointed. Too much faith is being placed on slack driving down inflation, which seems risky given that the impact of slack (however measured) on inflation has historically been unstable. Looking at CPI risks to the forecast, they appear all tilted to the upside: oil prices, a weaker EUR (i.e., higher oil and commodity prices, priced in USD), and sticky CPI expectations. But these upside risks may not materialise for a while, we think. And as a consequence, a stronger HUF is not needed from a disinflationary point of view. On the contrary, given how reliant the economy is on exports at the current macro juncture, we think the NBH would react much like the CNB or the NBP to pronounced currency gains, i.e., by trying to stem its rise, either verbally or by intervention. It was interesting in this respect that Vice-Governor Karvalits said in a recent interview that there is no need for tighter monetary conditions via FX, and although the NBH would rather refrain from intervention, it cannot categorically rule it out.

Euro adoption: window for 2014 according to some locals, though we doubt chances are high. Some of the locals we met believe that Hungary has a real window for EMU entry in 2014, which implies ERM II entry early next year. We do not rule this out, but we doubt it, for two main reasons. First, the odds are that Fidesz will want to assess scope for an upward revision to the deficit first, then assess scope for structural reform, while at the same time negotiating room for manoeuvre with the IMF: such a time of profound change seems hardly the most ideal time to enter a commitment to adopt the euro, especially as we think growth is unlikely to rebound to 3-4% for some time, which will make meeting the criteria on deficit that much more difficult. It is noteworthy that in a recent interview Matolcsy (candidate for Econ Ministry) sounded quite cautious on the whole EMU issue. Second, as we stressed many times, the current appetite for euro area expansion from within the ‘core' EU appears limited, in the light of the current troubles with Greece. The argument that ultimately Hungary has to adopt the euro like every other accession country and therefore the EU will have to accept a euro-zone expansion is weak, in our view. The EC/ECB still have plenty of leeway on the timing of that accession. And we think they will be inclined to use that flexibility. So, the door is definitely not shut, but especially at the time of ERM II entry, the scrutiny will be severe. When we think ahead to euro area entry, we think the biggest obstacle might be meeting the inflation criterion, rather than the deficit: Hungary has a golden opportunity to move to a lower inflation environment, but we note that it has been effectively stagnating or in recession for three years and yet it still does not meet the Maastricht inflation criterion (true, partly due to administered prices and tax changes). Realistically, Hungary needs to target CPI in a 1.5-2.0% range to ensure compliance, a very tall order indeed. On the deficit, the numbers look better: the cyclically adjusted budget deficit stands at 2.6% of GDP, according to the European Commission - one of the best in the whole of the EU (of course, with all the caveats mentioned above).

Local liquidity remains abundant, which should help front-end rates lower in the short term.  Household and corporate lending slowed sharply, the loan to deposit ratio has come down and local banks have parked most of the extra liquidity with the central bank.  A local bank mentioned that it shifted a portion of its investments from NBH bills to government bonds over the past year, in order to hedge against its deposit business.  The strong demand from local banks partly helps to explain the HGB rally since mid-2009, as foreigners have remained under-invested since the financial crisis.  Although our call is for the policy rate to bottom at 5%, we see downside risks to this forecast.  We think that there is scope for front-end rates to overshoot on the downside, especially if the forint remains strong.  On top of this, local liquidity should remain flushed in the near term, positioning is light among foreigners and we do not think there is much selling pressure among the local investor community either.

Long end spread to EUR should remain anchored.  On the topic of convergence, euro-zone entry should be a joint decision between the government and the NBH.  Despite the recent problems in Greece, the NBH remains pro-EMU, though acknowledging that appetite for enlargement is probably low. While euro-zone entry inevitably means that the NBH will lose its monetary independence, the sacrifice is deemed worthwhile, as the bank did not manage to exercise that independence during the 2008 financial downturn anyway, especially as the outstanding FX loan issue remains substantial and letting the forint weaken even more sharply in order to stimulate the economy was not an option.  Euro-zone entry will also serve to reduce/eliminate the exchange rate volatility of the CHF and EUR loans taken up by the Hungarians.  What is interesting is that the local banks no longer offer CHF mortgages after the freeze-up in the CHF funding market two years ago, and therefore almost all the new FX loans are now denominated in EUR. Of course, all this is happening in an environment of very low credit creation.  While the new mortgage extension has been low, the ‘stock' of FX loans outstanding remains high (around 37% of GDP).   The willingness of the government and the NBH to remain committed to the whole euro-zone project should anchor the long end of the rates curve, especially versus EUR.  Barring any significant changes in risk appetite, we believe that levels above 250bp should be attractive to initiate a HUF/EUR 5y5y receiver position. 

Potential for pre-funding of external debt in 2H10.  From our conversation with the AKK, the external debt service (interest payment and amortisation) in 2011 of around US$3.7 billion is higher than in 2010.  Even though AKK is fully funded for this year, it is possible that it will issue some external debt in 2H10 to pre-fund for 2011.  Encouragingly, we were informed that it no longer needs to rely on the IMF loans, given the cash reserves and liquidity cushion that it has accumulated thus far (e.g., OTP bank has repaid the €1.4 billion loan, which also forms part of the liquidity buffer).  Indeed, AKK did not withdraw from the last two IMF loan tranches in 4Q09 and 1Q10, as it has been able to fund itself quite comfortably in the domestic bond market.  On domestic bonds, the AKK will maintain the average duration of outstanding bonds at 2.5+/- 0.5 years (currently around 2.6 years). In order to reduce redemption risks, the AKK is looking to roll over some of the maturity T-bills into longer-dated bonds, mostly in the 3y sector.   Given the abundant liquidity among the locals, this should remain feasible in the near term, in our view.

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United States
Review and Preview
April 20, 2010

By Ted Wieseman | New York

Treasuries posted big gains the past week, led by the intermediate part of the curve, with most of the upside coming in a big rally Friday in response to the first meaningful decline in equity and credit markets in some time.  Prior to that, the market was a bit higher after four days of choppy and indecisive trading, with the impact of another run of strong incoming growth data offset by a benign inflation report and continued dovish Fed rhetoric that made the sizeable carry and roll-down support from the current very steep yield curve more enticing for now.  Incoming data continued to show an acceleration in growth in March after the run of surprisingly resilient numbers for February despite the severe weather, with good results for retail sales, industrial production and housing starts in March on top of upward revisions to February.  Upside in underlying retail sales in recent months led us to boost our 1Q consumption forecast to +3.8% from +3.5%, and the surprising strength in housing starts the past couple of months despite the rough February weather pointed to a smaller decline in residential investment.  The trade balance in February was wider than expected, however, and underlying details on capital goods negative for domestic investment.  So, by the end of the week, we still saw 1Q GDP growth tracking at 3%.  We continue to expect a further improvement in 2Q to +3.5%.  CPI inflation remained quite benign through March, however, which contributed to continued dovish Fed rhetoric and continued to raise expectations that the extremely dovish "exceptionally/extended" FOMC language, which is the only thing that really matters in the FOMC statement at this point, would probably be retained at the upcoming FOMC meeting.  The surprising lack of further movement by the Fed towards scaling back its emergency policy stance, however, continues to keep inflation expectations somewhat elevated, which we expect to lead to core inflation bottoming out soon and starting to move gradually higher in 2H, as slack in the economy continues slowly to decline.  Before too long we expect this to shift the Fed into tightening mode, but for now there is little movement in that direction, and it's hard to be short Treasuries when the curve is so steep and carry and roll-down thus so positive when an imminent catalyst for the increasingly widely expected eventual big backup in yields isn't currently in sight. 

On the week, benchmark Treasury yields fell 8-17bp, led by the intermediate part of the curve, with most of the gains coming Friday as stocks sold off.  The 2-year yield fell 11bp to 0.95%, 3-year 10bp to 1.54%, 5-year 17bp to 2.47%, 7-year 15bp to 3.19%, 10-year 12bp to 3.77%, and 30-year 8bp to 4.67%.  T-bills seemingly would have been helped in normal circumstances in a move out of stocks like Friday, but notable further upward pressure on financing and interbank rates stood in the way.  The Treasury overnight general collateral repo rate moved up to a new recent high of 0.24% on average Friday and effective fed funds was just behind this and near the top end of the Fed's official (but kind of meaningless, since the Fed has limited ability to guide effective fed funds independent of the rate being paid on excess reserves) target 0% to 0.25%.  TIPS performed quite well despite a weak CPI report and flattish commodity prices, as the longer-term implications of the Fed's policy stance remains somewhat worrisome to investors despite how benign recent inflation results have been.  The consumer price index ticked up 0.1% in March, boosting the annual rate a couple of tenths to +2.3%.  Energy prices were flat, as the beginning of the spring run-up in gasoline prices was in line with seasonal norms.  Core CPI just rounded down to 0.0%, lowering the year-on-year rate to +1.1% from +1.3%.  Core results reflected a familiar story of continued weakness in shelter (-0.1%), offsetting small upside elsewhere.  Shelter is now at -0.6%Y and core ex shelter a much higher +2.4%.  We expect that overall core CPI inflation to bottom out slightly below +1% over the next few months as rents start to gradually turn in line with the topping out in vacancy rates and upturn in home prices seen over the past year.  The 5-year TIPS yield fell 11bp to 0.24%, 10-year 10bp to 1.44%, and 30-year 9bp to 2.02%.  Swaps, mortgages and agencies outperformed Treasuries, which continue to be weighed down by supply concerns even if this is not a focus issue during the current two-week supply break.  After a lot of volatility in late March and early April, spreads settled down over the course of the week, with the benchmark 10-year swap spread ending the week at -2.75bp Friday, down 1.25bp on the week.  Current coupon mortgage yields came down to near 4.4% from 4.55%, which should keep 30-year mortgage rates only a bit above 5% on average for now, where they've been almost all year aside from a brief run-up to 5.25% a couple of weeks ago during the worst of the recent sell-off in rates markets.  Good mortgage performance was helped by a significant drop in volatility.  3-month X 10-year normalized swaption volatility fell 8bp on the week to 94bp, back not far from the lows since late 2007 near 90bp hit in mid-March before some upside during the sell-off that started after St. Patrick's Day. 

Equity market volatility, on the other hand, saw some upside after having plummeted to its lowest level in almost three years into Monday.  Stocks have been moving so little recently that not really all that big moves by the S&P 500 of +1.1% on Wednesday and -1.6% Friday were two of the biggest three moves in two months (the other coming when the February employment report was released in early March).  For the week as a whole the S&P 500 dipped only 0.2%, but these bigger swings caused the VIX to rise from a low to 15.6% Monday to 18.3% Friday, a three-week high.  Financials were down sharply in Friday's sell-off, but for the week only fell about 1%, outperforming the more defensive healthcare and utility sectors.  The industrials, technology and consumer discretionary areas were all up about 1% on the week.  Investment grade credit similarly ended a bit lower after a reversal Friday, with the IG CDX index widening 5bp Friday to 87bp, 1bp wider on the week.  High yield did better, though, with the HY CDX index 37bp tighter on the week at 469bp through Thursday and only widening back about 15bp Friday.  Meanwhile, even after some softness Friday, the subprime ABX and commercial mortgage CMBX markets posted huge gains on the week to extend a major rally over the past couple of weeks since the Administration released its mortgage principal forgiveness proposals.  The AAA ABX index surged 8% on the week.  The AAA CMBX did quite well with a 4% gain, but this was way behind much bigger spikes in the lower-rated indices - junior AAA 17%, AA 22%, A 25%, BBB 23% and BBB- 23% - which were all flat to down on the year before this week and are now way up. 

The recent run of strong data continued in the latest week, with strong March results for retail sales, manufacturing production and housing starts, extending what's been a run of across the board robust data so far at the end of 1Q, which follows results for February that continue to look a lot better than might have been expected, given the severe weather.  Indeed, February resilience looked even more impressive after upward revisions to retail sales, IP and starts.  The trade report for February was weaker than expected, however, so while we revised up our estimates for consumption, residential investment and inventories over the course of the week, a softer outlook for net exports and business investment based on the mix of capital goods exports and imports left our 1Q GDP forecast steady, ultimately at +3.0%.  This remains a full percentage point better than we anticipated at the beginning of March before the bulk of the February and March economic data had been reported.  And the upside momentum in March continues to point to a growth acceleration into 2Q. 

Underlying retail sales growth wasn't quite as strong in March, as suggested by the chain store sales results (possibly as a result of seasonal adjustment issues with the early Easter that could be reversed in the April report), but this was more than offset by upward revisions to prior months, and we boosted our 1Q consumption estimate to +3.8% from +3.5%.  Retail sales surged 1.6% in March, with motor vehicle sales gaining 6.7% and ex auto sales rising 0.6%.  This was a slightly lower-than-expected gain in ex auto sales, but there were more than offsetting revisions to February (+1.0% versus +0.8%) and January (+0.6% versus +0.5%).  We see overall real consumer spending surging 0.5% in March and February being revised up to +0.4% from +0.3%.  Not only would this result in a robust 3.8% gain in 1Q consumption, but the acceleration into the end of 1Q would provide a strong starting point for 2Q.  Indeed, with this starting point, it would only take sequential gains of 0.2% in real PCE in April, May and June for consumption growth in 2Q to reach +3.5%.  The near-term outlook for residential investment also looked a bit less negative in 1Q after a surprisingly strong housing starts report.  Near-term upside here is unhelpful in the medium term, however, as it would delay normalization in bloated inventories of unsold new homes.  Housing starts rose 1.6% in March.  Coming on top of a big upward revision to February, this left them at 626,000, a high in a year-and-a-half.  Single-family starts now show surprising strength over these two months, surging 6% in February to 536,000 despite the severe weather and then dipping only 1% in March to 531,000.  These were the two highest readings since the fall of 2008 after a run since last summer of stability near 500,000.  Multi-family starts, on the other hand, remain severely depressed even after a 19% gain in March to 95,000, which is supporting stabilization in apartment vacancy rates and a pick-up in rents.  Incorporating the upside in starts, we now see residential investment declining 11.5% in 1Q instead of 13%. 

Offsetting this upside was a softer-than-expected trade report for February.  The trade deficit widened a bit more than expected in February to $39.7 billion from $37.0 billion, as exports only gained 0.2% while imports jumped 1.7%.  Exports have flattened out in the past couple of months after surging 28% in the initial rebound during the last eight months of 2009.  Overall capital goods exports showed only a modest gain, but only because of a big pullback in aircraft.  Ex aircraft capital goods exports surged, indicating that most of the upside in core capital goods shipments in February went overseas instead of into domestic investment.  And core capital goods imports were down slightly, also a negative indication for domestic investment.  Based on the slightly wider-than-expected trade deficit, we now see net exports subtracting 0.3pp from 1Q growth instead of 0.2pp, with growth in imports (+8%) expected to outpace growth in exports (+7%).  We look for trade to swing to a meaningful net positive over the rest of the year as emerging markets demand appears to be running quite strong relative to the more muted recovery in US domestic demand.  Certainly, the 66% spike in Chinese imports in March was very supportive of this outlook.  Meanwhile, incorporating the surge in ex aircraft capital goods exports, we lowered our 1Q forecast for equipment and software investment to +1% from +4%, which along with an expected further plunge in structures lowered our forecast for overall business investment to -5% from -3%.

Adding up positives from consumption and residential investment and a slightly larger expected boost from inventories after incorporating new motor vehicle inventory figures (we now see inventories adding 1.3pp to 1Q instead of +1.0pp on top of the 3.8pp boost to 4Q) and the negatives for net exports and business investment, we continue to see 1Q GDP growth running at +3.0%.  And we still look for a pick-up to +3.5% in 2Q. 

Amid this still rather modest rebound from such a severe recession, though with upside risks becoming increasingly apparent, manufacturing continues to outperform, posting a more typically V-shaped rebound, with big further upside in production in March and indications from initial regional surveys of continued strength into April.  Manufacturing output jumped 0.9% in March, bringing the rebound since the mid-2009 trough to a robust 9% annualized.  Autos led the initial turnaround and saw another big rise this month, but the factory rebound has become quite broadly based over recent months, with ex motor vehicles manufacturing up 0.8% in March on big gains in a number of important industries.  The initial regional manufacturing surveys for April indicated that the upside has extended into the spring.  An ISM-comparable weighted average of the key activity measures in the Empire State manufacturing survey rose to 59.6 from 57.1, high since early 2006, and the Philly Fed rose to 53.4 from 52.8.  Based on these results, our preliminary forecast is for a half-point rise in the national ISM to a lofty 60.0.

The near-term economic calendar is quiet, with little due out the first part of the coming week and a handful of notable releases Thursday and Friday, so earnings reports, risk markets performance and overseas developments will likely drive interest rate markets largely.  After a break of a couple of weeks, supply will move back on the agenda Thursday when the 5-year TIPS, 2-year, 5-year and 7-year that will be auctioned the last week of the month will be announced.  Sizes should all be unchanged, but if the key tax season inflows that will be tallied up in coming weeks show solid growth, then we think the Treasury will probably start trimming record coupon sizes at the May refunding.  Data releases due out in the coming week include leading indicators Monday, PPI and existing home sales Thursday, and durable goods and new home sales Friday:

* Following a couple of months of more modest increases, the index of leading economic indicators is likely to surge 1.3% in March.  This will mark the 12th straight increase for an expected 11%Y gain, the best performance since January 1984.  Positive contributors in March should include the yield curve, manufacturing workweek, supplier deliveries, stock prices, jobless claims and building permits.

* We forecast a 0.5% increase in the overall producer price index in March but a flat core reading.  A jump in wholesale gasoline prices, combined with rising quotes for some food items (specifically, fruits, vegetables and meats) should lead to a rebound in the headline PPI.  Meanwhile, the core is expected to be flat for the third time in the past four months, reflecting some modest discounting in the motor vehicle sector and continued softness in apparel pricing.

* We expect existing home sales to rise to a 5.20 million unit annual rate in March.  The recent jump in applications for new home mortgages implies a pick-up in home sales.  We look for resales to jump about 3.5% in March, spurred by the looming expiration of the homebuyer tax credit.  Also, fears that mortgage rates may be on the rise could have helped to motivate some fence-sitters. 

* We forecast a modest 0.5% rise in March durable goods orders despite anticipated declines in a couple of the most volatile categories - aircraft and defense.  In fact, the key core component - non-defense capital goods excluding aircraft - is expected to be up more than 1% this month.  Company reports point to a bit of slippage in bookings of aircraft, while the recent elevation in the defense sector appears unsustainable. 

* We look for March new home sales to rise to a 325,000 unit annual rate.  The looming expiration of the homebuyer tax credit, combined with concern about rising mortgage rates, is expected to have helped give sales of newly constructed residences a boost in March.  Our estimate implies a 5.5% sequential rise.

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United States
Don't Be Sidetracked by the Inflation Measurement Debate
April 20, 2010

By Richard Berner | New York

Will the real core inflation measure please stand up?  However measured, core inflation has declined over the past year.  Measured by the CPI, inflation excluding food and energy has declined by half a percentage point to 1.1% over the year ended in March, and by 0.4 percentage points in terms of the personal consumption price index (PCEPI) to 1.3% (the latter by our estimates).  Other measures of inflation trends, like the Cleveland Fed's trimmed mean measure of PCE inflation, was only 1% in the year ended in March, down from 2.4% in the prior 12-month period.  Slack in the economy - in product, housing and labor markets - has promoted a broad-based decline, and for now, there is little sign of a reversal.

Depending on the metric, however, the deceleration in rents arithmetically has accounted for most - or more than all - of the core inflation decline to date.  In the CPI, the gap between the published core rate and the core excluding housing services (rents) is 70bp, as rents account for fully 40% of the core CPI.  By contrast, the same gap is only 30bp in the PCEPI, reflecting the fact that housing accounts for only 18% of that index.  Obviously, in the CPI, other factors such as medical care services have been an offset to declining rents.   

These differences in inflation measures have triggered a debate about how to measure core inflation and whether it has truly declined; we think this debate has obscured the real controversy about the inflation outlook.  Rather than focusing on the arithmetic and minutiae of inflation measurement, we think the factors influencing the outlook are what really matter, and we see forces in train that will promote a bottoming in inflation.  In addition, the measurement debate demonstrates that it is wise to look at more than one metric, especially when some like the PCEPI are subject to significant revisions over time. 

The outlook by any measure is what matters.  Inflation has declined a bit faster than we thought six months ago.  In October 2009, for example, we forecast that core inflation measured by the CPI would decline to 1.4% in 1Q from the same quarter a year ago, or 10bp higher than the number just reported (we don't publish monthly forecasts, but that is roughly consistent with a forecast miss of similar magnitude for March compared with a year ago).  But that faster slide has not changed our outlook: We still think that core inflation will decline to about 1%Y and begin a slow process of bottoming out and turning higher.  At first blush, it may sound counterintuitive, but as we see it, the Fed has contributed to that process: By continuing to guard against deflation tail risks and lingering imbalances in housing, the Fed has boosted inflation expectations and prevented a further decline in inflation.  More broadly, the Fed's track record of promoting price stability - an inflation rate neither too high nor too low - over the past three decades has loosened the relationship between slack in the economy and inflation, flattening the so-called Phillips curve.  

We're not alone in that view.  For example, Fed Vice-Chairman Don Kohn seems to share that perspective, noting recently that anchored inflation expectations can limit the downside as well as restraining the upside.  He noted:

Although the persistent high level of unemployment will tend to restrain inflation further, the effect of resource slack on inflation does not appear to be as great as some previous episodes might have led us to expect.  The difference is that inflation expectations now appear to be much more firmly anchored than they once were, probably reflecting the extended period of low inflation that we have experienced and a credible monetary policy directed at sustaining this performance.  I anticipate that inflation will remain low for a while, with core PCE inflation not likely to fall much further from the subdued pace I cited a few minutes ago. 

Three forces pushing inflation higher.  More controversial, we also believe that a further rise in inflation expectations and a narrowing of slack in the economy - in product, housing and labor markets - will change the Fed's inflation outlook and warrant a gradual change in monetary policy in the next six months.  Indeed, we believe that three factors will push 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, speed effects are strongest for wholesale or producer prices, but in turn we believe that they matter for consumer prices as well.

Expectations starting to rise again.  Market-based measures of inflation expectations are beginning to rise slowly but surely.  Five-year, five-year forward inflation breakevens based on current-coupon rates have edged up from about 2.4% in early March to 2.75% lately.  The Fed's version of the same concept, based on off-the-run securities and a smoothed yield curve, has moved in tandem, if by a smaller amount, to just about 3%.  Neither is alarming, of course, but a further rise to new highs would signal that inflation risks were tilted higher.  So far, survey-based measures are stable; in late March, median long-term inflation expectations in the University of Michigan canvass remained at 2.7%.

What does the evidence say about slack in housing, goods and labor markets?  In housing, there is still substantial slack, evidenced by the high levels of rental and homeowner vacancy rates; nationwide, in 4Q they stood at 10.7% and 2.7%, respectively.  And there is a not-insignificant risk that rising foreclosures will increase the stock of vacant homes.  Importantly, however, both rental and homeownership vacancy rates have declined from their peaks.  We suspect that this change caused rents to stabilize in 4Q, and both anecdotal evidence and tenant rents in the CPI suggest that rents began to recover in 1Q.  Reis Inc., a New York research firm, reported last week that rents rose in 60 of the top 79 US markets, paced by Miami, Seattle and New York.  Measured by the CPI, ‘rent of primary residence' rose slightly in the three months ended in March.

Finally, two policy changes - a new ‘earned principal forgiveness' initiative in HAMP (Home Affordable Modification Program), and the short refinance program through the FHA - will reduce the downside tail risks to home prices and housing.  If implemented effectively, these changes, by strongly encouraging principal write-downs, will help reduce the ‘shadow inventory' of yet-to-be foreclosed homes and the likelihood of strategic defaults. 

In product markets, companies continue to cut capacity aggressively, contributing to the 440bp rise in industry operating rates over the past nine months - the fastest nine-month jump since 1983.  That is the result both of the export-fueled production rebound in manufacturing and of efforts to rein in capacity.  Measured by the Fed's capacity data, capital exit has taken overall industrial capacity down by 1.2% over the past year, the fastest pace on record.  With production growing and capacity shrinking, we see factory operating rates rising another 400bp to 73-74% by the end of 2010.  And finally, in labor markets, we believe that the unemployment rate peaked last October at 10.1%.

Global factors.  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 product quotes jumped at a 15-25% annual clip in the six months ended in March.  While our commodity team believes that the longer-term direction is higher, some consolidation is likely.  Measured in the CPI, meanwhile, US retail food prices have also accelerated - to a moderate 5.7% annual rate in the September-March span.  But the strength of global demand is likely to push food prices higher still.  Finally, US import prices are beginning to turn up again: Prices on consumer goods ex autos rose by 0.8% in the year ended March, the first such increase since January 2009.

Two lessons from the measurement debate.  There are two lessons from the measurement debate and the dissection of inflation barometers.  First, investors should look to a variety of core inflation measures to judge short-term inflation trends, rather than relying exclusively on any one gauge.  While the Fed must pick one metric to communicate its forecast and implied inflation target, officials are well aware of the pitfalls of measurement, some of which we've noted above.

Second, and related, data revisions have in the past affected the Fed's preferred price index, the personal consumption price index (PCEPI).  Revisions can significantly affect perceptions about inflation risks, so it is important to assess the variation in that inflation gauge in comparison with other measures. 

The July 2005 revision of the National Income and Product Accounts (NIPAs) is a case in point.  Prior to that revision, it appeared that core inflation measured by the PCEPI remained extraordinarily benign.  Through the year ended in May 2005, core inflation so measured was just 1.6%, having drifted up very slowly to the lower end of the Fed's presumed inflation range.  Then, in the annual NIPA revisions in July 2005, the Bureau of Economic Analysis revised up the 2004 growth rate for PCE prices by 0.4pp.  Core PCE inflation in May 2005 was revised up to 2%, the upper end of the Fed's presumed range.  Markets reacted by raising the expected future path of the funds rate, and the Fed raised its inflation forecast.  As the Fed noted at the August 2005 meeting: "Notwithstanding recent benign readings on inflation, the forecast for core PCE inflation was raised somewhat, owing in part to the recent further rise in energy prices and, in light of the revisions to historical data, a higher assumed trajectory for the non-market component of core PCE prices".  That experience suggests that investors should interpret initially reported price data from the NIPAs with caution; what appears to be sharp disinflation today may be tempered by subsequent revisions.

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