Canada
The Grass Is Greener on This Side
May 14, 2010

By Yilin Nie & David Cho | New York

Riding the NAFTA Tailwinds

On the back of our economists' upward revisions to the US growth profile, we are upgrading our Canadian outlook again.  We now expect 2010 growth in Canada to reach 3.6% (3.4% previously), higher than the US and the fastest among the G10 economies.  We also bumped up our 2011 forecast from 3.0% to 3.1%.  Many of the factors driving the growth engine have gained momentum, led by the strong trends in domestic demand and the labor market recovery.  Meanwhile, the improving prospects for Canada's largest trading partner also imply trade benefits via the export channel.  Not surprisingly, the largest downside risk comes from the sovereign debt concerns centered on Europe, and the potential for negative spillover.  That said, we believe that recent actions taken by policymakers have ring-fenced the problem and greatly reduced the possibility of this outcome.

We maintain our call that the Bank of Canada will begin tightening in June.  Our sense is that domestic conditions have improved enough to warrant a response from the BoC sooner rather than later.  We acknowledge the risk that further deterioration in external factors could give the bank latitude to wait until July, but this is not our central case.  Following the June hike, we expect the BoC to go at steady 25bp clips, leaving the target at 1.50% by year-end.  This is lower than our prior expectations for 2.00%, consistent with the new Morgan Stanley forecast for the Fed to be on hold this year.

G10 Strongman

By far, the biggest component of the Canada growth pie this year and next continues to be domestic demand.  Since our last update, we have seen the positive momentum from the Canadian consumer extend, as evidenced in several consecutive months of rising retail sales and strong housing activity.  Indeed, while Olympic-related effects had some temporary impact on accommodation and media sectors, the majority of strength has been seen in manufacturing, which is a core component of real economic growth. 

Most encouragingly, we have seen a definitive turnaround in the labor situation.  Canada posted historic gains last month, with gains of over 100,000.  For comparative purposes, this would proportionally equate to a gain of nearly 1 million in US payrolls.  Overall, the economy has added around 285,000 jobs since employment began trending up in July 2009, and the unemployment rate also continues to tick lower, a trend which we expect will continue.  Importantly, the data also showed private businesses, not the government, doing the majority of the hiring.  This indicates a healthy transition from public- to private-sector driven growth, adding credibility to the sustainability of the economic recovery. 

The better outlook for the US economy provides an important tailwind for Canada, given the strong trade linkages between the two economies.  The US remains the destination for over three-quarters of Canada's exports, while AXJ is the next largest at around 14%.  We had previously expected Canadian exports to be tepid relative to imports this year, detracting nearly 2pp from growth.  But a stronger US consumer and buoyant global demand, especially in Asia, bode more positively for Canada, helping to shrink the drag from net exports on the margin.  Persistent CAD strength presents a risk factor, although USD/CAD has remained at or above our assumed range for the forecast horizon.  Unless we see a sustained break beneath parity, we would not need to revise these assumptions.  It is also worth pointing out that the eurozone's share of Canadian exports is also marginal, around 3%.  We realize that a growth contraction overseas could trickle through to Canada, especially if the US is negatively impacted (see US Economics: A European Slowdown Would Only Nick the US, February 12, 2010), but our general sense is that the risk is limited for now.  

Inflation to Reemerge

The recent inflation data caught the market's attention with a larger-than-expected fall-off in prices.  We would be wary of reading too much into the March report due to transitory effects.  As StatCan noted, much of the drop was Olympics-related, with prices for travel tours and accommodation normalizing after the one-off event.  Excluding the Olympics impact, most other categories were actually higher. The BoC has also pointed out that auto prices played a role, as the typical price erosion occurred later than usual this year. 

We suspect that these temporary effects should fade and lift core CPI back to 2.0% in 2Q.  In the bigger picture, the overall trend of inflation is trending higher, with 1Q core CPI averaging out at 2.0%.  The next inflation report on May 21 will be an important risk event.  If the downward trend continues, it would give the BoC more leeway before hiking.  But we believe that price pressures should pick up again for several reasons.  For many months, we have seen persistent pressures in the Canadian housing market that tend to show up in CPI with a lag.  Our commodities team also expects prices to rise higher by year-end, forecasting crude oil at US$95/bbl.   Finally, the inflation threat could be amplified by the fact that productivity growth in Canada has been muted, which suggests that the output gap may close faster than the BoC expects. 

BoC on Balance Beam

Last month, the BoC surprised markets by removing its pledge to keep rates on hold until end-June 2010.  This was consistent with our view, and we continue to believe that the risks are skewed towards a June hike (see CAD: Bank of Canada Dons Its Hiking Gear, April 22, 2010).  Since April, we have gathered more evidence of a solid domestic recovery.  From the perspective of its own economy, Canada has met all the necessary preconditions for the BoC to begin raising rates - stronger markets, robust growth, a narrowing output gap and rising inflation. 

That said, the external risks have increased significantly over the past month, enough to warrant Governor Carney to cite the concerns over European sovereign debt as the major risk factor for the Canada.   We acknowledge the potential for these risks to keep the BoC on hold for longer, especially if we see renewed concerns that trigger another broad flight to quality.  To some extent, the BoC's removal of its commitment constitutes a form of tightening, a point which the bank has made to buy itself more flexibility.  But our sense is that the measures that policymakers have taken in recent days will help stabilize markets and quell these risks, at least in the near term.

Following the hike in June, we expect the BoC to continue at steady 25bp clips per meeting, to leave rates at 1.50% by year-end.  Previously, we had been expecting a higher target of 2.00%, on the assumption that the BoC would speed up its tightening after the Fed begins hiking.  With the new Morgan Stanley forecasts for the Fed to stay on hold until early 2011, it is more likely that the BoC will move at a gradual pace this year.  But, it is unlikely to be held back by the on-hold policy of the Fed if the pace of the domestic expansion continues at the same speed.  While the BoC and Fed have moved in tandem in recent years, it is worth pointing out that rate divergence is not unprecedented.  In early 2002, the BoC commenced a tightening cycle while the Fed was still easing.  This created a spread of about 150bp at the peak before we saw convergence again. 

Looking ahead into 2011, the BoC anticipates growth to return to trend against fading stimulus measures and a somewhat weaker outlook for the US economy in 2H.  This suggests that the tightening pace may slow next year, especially if the BoC starts hiking before the Fed.  Indeed, the bank has expressed long-run concerns regarding the strength of the CAD, poor productivity and weaker US demand.  These factors may suggest the need for a lower neutral policy rate in the future.  We leave our end-2011 target at 3.25%, which implies fewer hikes from the BoC than the Fed next year.   

Other Risk Factors

We have already mentioned that the largest source of uncertainty in our assessments involves Europe and sovereign debt issues.  While Canada is shifting from being export-dependent to more consumption-driven, it remains an open economy that is sensitive to the ebb and flow of global demand. Severe austerity measures that lead to a growth slowdown would impact open economies the most, Canada included.  EM economies play a large role in this equation and any wobbles, especially in AXJ, would introduce more downside risk for the Canadian outlook.

The US outlook is another critical component.  If growth in the US proves more muted for any number of reasons, there would be clear downside risks to our Canada forecasts.  One source of divergence between our forecasts and the BoC's is expectations for US growth.  While the BoC expects the US to slow in the second half of this year, our economists see a more robust pace of growth.  These assumptions are an important input in our Canada forecasts and present considerable risks in both directions to our base case.

Finally, the BoC has frequently cited the CAD as a source of risks in its forecasts.  CAD appreciation may become more pronounced if the BoC hikes as we expect and widens rate differentials with the Fed.  If we see sharper and longer-lasting CAD strength, this could affect our inflation profile and export forecasts.  But, our sense is that markets have already priced in expectations for the BoC to hike this year, and the moves should revert once the Fed begins to tighten early next year.  As such, we do not believe that this should significantly alter our projections.

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United Kingdom
BoE Inflation Report
May 14, 2010

By Melanie Baker, CFA & Cath Sleeman | London

No significant impact on our view: There was little in today's Inflation Report to change our view on rates. The MPC still appears in no hurry to tighten monetary policy. We continue to expect no monetary policy tightening in 2010. We still expect the first rate rise to come in 1Q11. However, with the new government agreeing that there needs to be "a significantly accelerated reduction in the structural deficit", the risks have grown for a later start to monetary policy tightening. We await the ‘emergency budget' for more details of these fiscal plans. It is not clear, however, that the new fiscal plans will have a significant downward impact on the Bank of England's growth forecasts.

BoE reaction to new fiscal plans: The governor was "very pleased" with the new government's commitment to accelerate the reduction in the deficit. Interestingly, Governor King thought that its fiscal plans would not affect the bank's central projections very much. Further, he felt that they would diminish some of the downside risks to the bank's outlook for growth (by reducing the chance of an adverse market reaction to the UK's fiscal position).

Bank's outlook broadly similar to February: Governor King described the "big picture" as being "very similar". However, the bank now sees greater downside risks to its near-term outlook for GDP growth. It has also lifted its central forecast for inflation over the near term, citing a range of temporary factors. However, this change looks relatively small. 

Comparison to our own forecasts: We expect more subdued growth than the Bank of England (as a central case), yet we expect similar inflation. 

Further Detail

BoE still sounds like a central bank in no hurry to raise rates: Our sense from today's Inflation Report remains that the BoE is in no hurry to tighten monetary policy. On its inflation forecasts that incorporate ‘market interest rates' (where the policy rate starts to rise in 4Q10/1Q11 and reaches around 3% by the end of 2012), CPI inflation looks below the 2% target two years from now and looks close to, but a touch below, the 2% target by 2013 (on the MPC's central forecast). Further, the bank thinks that inflation (using market interest rates) is more likely to be below than above target for much of the forecast period.

BoE GDP growth outlook: The bank's outlook for growth is very similar to its outlook in February. Its central or modal forecast for growth rises sharply this year and thereafter stabilises at what looks like around 3-4%. In its February Inflation Report, the bank considered that the risks to its central outlook for growth were skewed to the downside.  Now, it perceives that this downside risk has increased over the near term. Commenting on last month's weak estimate of growth in 1Q, the bank said that the weakness probably reflected temporary factors, and it noted that business surveys had pointed to faster growth in 2Q.

BoE inflation outlook: The bank's central outlook for inflation appears broadly unchanged from February. It expects inflation to fall below the 2% target over the next 12 months and trough in mid-2011. Thereafter, its central forecast rises to just below the target of 2% at the end of the forecast horizon (1H12). In comparison to its February forecasts, the bank has lifted its near-term forecast a little. As a result, the implied probability of inflation being above target is now slightly higher over the next 12 months. Additionally, the bank's projected trough in inflation appears to be slightly shallower and the eventual rise in inflation looks more gradual.

Other Interesting Points

More on the new government's fiscal plans: The Inflation Report went to press on Monday and therefore did not incorporate any of the new fiscal plans from the Conservative-Liberal Democrat government. However, the governor had been consulted on these plans and he described them as a very strong and powerful agreement to reduce the deficit. The governor felt that they would diminish some of the downside risks to the outlook (by reducing the risk of an adverse market reaction that may have otherwise pushed up the yield curve and reduced demand). 

On banking supervision: Governor King said, referring to the coalition agreement, that "the agreement does suggest that the Bank of England will be asked to be responsible for macro prudential regulation and it will have an oversight role in micro prudential regulation". More detailed plans from the new government are expected to be released in due course and may shed more light on this issue.

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Global
The Unwelcome Trinity for Emerging Markets
May 14, 2010

By Manoj Pradhan | London

The massive €750 billion package to ring-fence sovereign credit risk and the ECB's recent additions to its policy stimulus greatly reduce the tail risks in the euro area and give a boost to baseline growth, respectively. Of course, this is no panacea for the underlying fiscal malaise that still remains in the euro area, and indeed in other parts of the world. The longer that these risks and issues remain prominent, the greater the possibility that markets could turn their attention to assessing the vulnerability of emerging markets (EM). Such a contagion or spillover could be transmitted to EM in the following manner: (i) the first phase would likely involve an examination of the vulnerability of EM external balance sheets; and/or (ii) in a second phase, a slowdown in global growth and trade could affect EM economies that are more reliant on exports or commodities (see Implications of EU Debt Concerns for Asia ex Japan, May 10, 2010). In order to help investors think through these risks, we draw on the regional expertise of our EM teams to differentiate the vulnerability of EM economies according to their exposure to both channels. Our base case is that sovereign credit risks are contained for now, and any slowdown in European growth could well be offset by stronger growth elsewhere as central banks delay tightening. EM economies will likely not be affected by contagion, but will have to factor in higher risks of a slowdown in DM and global growth in their policy decisions.

A quick summary of results: The AXJ region stands out as the best equipped to withstand contagion or spillovers from developments in the EU. External balance sheets are strong, and most of the countries that are exposed to global growth and trade have the option to deploy either monetary or fiscal policy, or both. Among the CEEMEA economies, Russia and Israel stand out as the most resilient economies, whereas Hungary looks the most vulnerable. In Latin America, however, no real pattern emerges, with Brazil, Mexico and Chile looking vulnerable on some counts but better on others. Our base case is that EM economies will not face widespread contagion risk and will continue to outperform DM, but the risks deserve close scrutiny.

A Rapid Spread - Contagion

External balance sheet vulnerability would be the first focus: A rapid spread of contagion to EM is likely to first focus on countries that have vulnerable external balance sheets. Their dependence on the capital flows or funding in international capital markets is likely to mean that these economies will be the most affected by any contraction of risk appetite or funding stresses. It is practically impossible to guess whether, when or where contagion will strike next, but the vast literature on contagion does offer some clues.

Research from Kaminsky, Reinhart and Vegh (2003) identifies an unwelcome trinity for financial contagion. The factors they highlight are: (i) capital flows; (ii) surprise announcements; and (iii) a leveraged common creditor. Of these, capital flows have been abundant, and commercial banks remain a likely conduit for transmitting shocks to the liabilities to the EM world (see Appendix). However, risks in the euro area have built up gradually and this appears to rule out rapid contagion. It is important to keep in mind, though, that investors have so far treated the EM world as immune to contagion or a slowdown. A surprise development in the EM world, or indeed contagion itself, could shake quite a few beliefs.

Our EM team assessed the vulnerability of external balance sheet. In CEEMEA, Hungary and Romania are most at risk because of their large external debt positions, with Turkey somewhere between neutral and vulnerable because of its current account deficit and low level of FDI. India's current account deficit and reliance on capital flows make it vulnerable too, just as it was in 2008 during the Great Recession. The rest of the AXJ region scores much better and has stronger external balance sheets, though Korea and Indonesia lag the rest, given their external debt obligations. In Latin America, Peru's dollarised economy and Chile's low dependence on external funding make them the most and least vulnerable economies in the region.

Later on - Spillover to Global Growth

Exposure to a global slowdown: Even if contagion does not strike EM economies, the persistence of sovereign balance sheet risks and the possibility of greater-than-expected fiscal tightening raises the risk of a slowdown in DM and possibly global growth. How and how much are EM economies exposed to a global slowdown? This depends on the balance between dependence on exports and the strength of domestic demand. Further, a slowdown in global growth and trade will likely result in a softening of commodity prices, which does not augur well for some economies. We classified economies into low, moderate and high exposure brackets according to their ability to withstand a slowdown in global growth and trade.

AXJ: The focal point of attention naturally rests on the export powerhouse - China. As one would expect, exports are a critical driver for the Chinese economy, but this does not mean that China is very susceptible to a global slowdown. Its all-but-bulletproof external balance sheet and strong ability to deliver both monetary and fiscal stimulus will likely insulate it effectively should the global economy indeed slow down. India and Indonesia with their robust domestic demand stories are naturally more immune, whereas Taiwan and the other ASEAN economies are more susceptible because of their export reliance. Interestingly, Korea, despite its export reliance, will likely be more comfortable because of its large exposure to China and a strong fiscal position.

CEEMEA and Latam: Turning to the CEEMEA region, most economies there have moderate to high exposure to global growth, with Hungary and the Czech Republic (due to their openness) and Ukraine (because of its reliance on steel prices) most at risk. Most Latam economies are only moderately exposed to global growth in spite of their commodity exposure due to strong domestic fundamentals. Only Mexico and Argentina will face difficulties if growth should slow down globally, in our view.

EM Policy Response

Both of the channels above discuss the vulnerability of EM economies to rapid and slow shocks. However, the economic performance of these economies also depends, as always, on the policy options available to EM policymakers. Many policymakers are constrained by the salvo of monetary and fiscal measures that was fired to stave off the Great Recession. Policy rates in many economies are at or close to historical lows so central banks may not have much room to cut rates. In some other cases, fiscal policy constraints are binding because of already high deficits, high debt, or both. Since EM central banks are still near or at the starting blocks for monetary tightening, one easy option they can exercise is to simply postpone monetary tightening, much as our euro area and US teams now expect the ECB and the Fed to do. EM economies, particularly those with fixed exchange rate regimes, should also benefit from the extension of the AAA liquidity regime in the major economies.

Do less: In a recent note, we have highlighted that AXJ central banks seem to be in no hurry to tighten policy (see EM Tightening: Think Locally, Rank Globally, May 6, 2010). Instead, it is central banks from CEEMEA and Latam regions that dominate the top of our ‘expected tightening ranking' as well as the ranking for the risk of aggressive action. Clearly, the first option for these central banks would be to not tighten or raise rates very slowly. Indeed, our China team now expects only one rate hike from the PBoC some time in 2H10, given our outlook for the ECB and the Fed to only hike some time in 2011 (see Moderation in Activity; Reflation; and Policy Normalization, May 11, 2010).

Policy flexibility: Region-wise, AXJ again comes up trumps with the most flexibility in terms of policy options. Importantly, all the economies (under our coverage) there are able to deploy either monetary or fiscal policies, or both. By contrast, in the CEEMEA as well as Latam regions, options seem limited for many. Ukraine and the Czech Republic are constrained on both the monetary and fiscal fronts while Russia, Turkey and Israel all have sufficient leeway on both fronts. In Latam, however, only Brazil enjoys this luxurious position. All the other economies there are constrained on monetary policy (Chile and Peru with very low policy rates already) or fiscal policy (Mexico due to concerns about fiscal sustainability, Colombia), or both (Argentina, Venezuela).

In summary, the differentiation in EM economies is critical to understand where the vulnerability to external balance sheet issues and exposure to a global growth slowdown lie. AXJ economies seem to be best positioned to ward off any ill-effects from developments in the EU. Risks seem to be the most widely spread in the CEEMEA region, while Latin American economies seem to be in the moderate range in terms of vulnerability. Of course, policymakers will not stand by idly. The ECB and the Fed are already expected to keep their policy rates lower for longer, and this should prompt many EM central banks to slow down their own tightening campaigns. Fortunately, only four of the EM economies we cover appear to have constraints on deploying monetary or fiscal counter-measures. All of the others have the option to use monetary or fiscal stimulus if needed, or both.

Appendix: A Trinity for Financial Contagion

Episodes of sovereign default have in the past triggered contagion to other parts of the world. But there have also been many instances when this has not happened. Kaminsky, Reinhart and Vegh (2003) use this contrast to isolate a trinity of factors that are singular to the case where contagion spreads rapidly: (i) a large surge in capital flows in the recent past; (ii) the announcements of default or restructuring come as a surprise; and (iii) a leveraged common creditor (commercial banks or hedge funds in past episodes). Since the crucial element of a surprise announcement has been notably absent in the developments in the euro area, the unwelcome trinity of financial contagion appears to be at arm's length from the EM world. However, investors should stay cautious because the situation is less clear-cut than a cursory look at these factors would suggest.

A closer look at the trinity: Of the three factors, EM economies have clearly been the beneficiaries of a large inflow of foreign capital since their markets recovered in March 2009. Portfolio flows can always be subject to rapid reversal, as we saw in 2008-09. The surprise element of the announcement usually serves as a trigger for capital outflows as investors jump to rebalance portfolios. Risks in the euro area have been closely followed, which has most likely given investors enough of an opportunity to take unwanted risk off their books. However, it is worth noting that the contagion of risks to EM is not yet in the price (and not our base case either), so assuming that investors have adjusted their portfolios to account for this risk is probably too strong a statement.

Finally, the role of a leveraged common creditor is all too familiar, given the stresses that occurred in international funding markets during the financial downturn. Our strategy team has been emphasising the role of DM funding markets as an early warning signal for contagion to EM markets (see EM Macro Strategy Update: The Path to EM Contagion, May 5, 2010). The unavailability of funding in international capital markets during the financial downturn was a shock to the balance sheets of banks. Recent empirical evidence by Cetorelli and Goldberg (May 2010, NBER Working Paper No. 15974) shows that international bank loans to EM fell from over US$500 million in 2007 to just above US$100 million in 2008, in part due to such funding shocks to the balance sheets of banks. Stresses of such severity are not expected to recur, given all the liquidity arrangements that central banks have on stand-by. The swap lines between the Fed and several other central banks that were reopened recently to relieve USD funding needs are an example. Commercial banks, however, are still not as strong as one would like, so any shocks to the liability side of their balance sheet (to their deposit base, funding costs, funding availability or bank capital) would need to be monitored very carefully.

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Global
XXL Liquidity
May 14, 2010

By Joachim Fels | London

Deflationary or inflationary? One of the key debates among investors is whether the sovereign debt crisis that has been roiling Europe is inflationary or deflationary for the global economy.  Judged by the decline in market-implied inflation expectations and also by many conversations we have had with investors, the majority seem to believe that it is deflationary, mainly because they expect the crisis to spring major fiscal austerity measures.  We beg to differ, for two reasons.  First, the big emergency fund put in place by eurozone governments last weekend creates moral hazard because profligate governments can now be sure that they will be bailed out at below-market interest rates eventually.  Second, and more importantly, the sovereign crisis has pushed the ECB into flooding the system with even more liquidity and into outright purchases of government bonds. It also implies that the Fed will probably keep interest rates at record-low levels for longer. This, in turn, will likely make it more difficult for many EM central banks to tighten policy in response to domestic inflation pressures.  Hence, global excess liquidity should grow by even more, lifting the prices of commodities and other risky assets and adding to global inflation pressures. 

Liquidity risk reduced, but how about solvency? The emergency measures announced by the Ecofin and the ECB over the weekend (see Europe Economics: Fast-Track to Fiscal Union? May 10, 2010) clearly reduce the liquidity risks for governments in the GIPS (Greece, Ireland, Spain and Portugal), but they do not address the underlying fiscal-sustainability issues. If anything, the creation of a backstop facility for government funding guaranteed by other euro area members and the massive intervention in recent days by the ECB and national central banks (NCBs) in what the ECB weekend statement called "dysfunctional" government bond markets might make future fiscal slippage by other governments more likely, because they can hope for an eventual bail-out if markets refuse to fund them.

How much fiscal tightening? However, this view is not widely shared by investors. Rather, the consensus seems to think that the events around Greece and the resulting contagion to other non-core euro area bond markets served as a wake-up call for governments and will be followed by substantial fiscal-tightening measures across the euro area. Indeed, this is likely to be the case for Portugal and Spain, who will both present additional fiscal-tightening measures to the ECOFIN next week in an attempt to convince markets that they can prevent debt levels from spinning out of control.  However, it is important to note that the GIPS countries, where fiscal policy is tightened significantly, account for less than 20% of euro area GDP.  In most other euro area member countries, especially in Germany and France, who account for more than half of euro area GDP, there are no signs that policy will be tightened significantly in the foreseeable future. This is why we think the fiscal-sustainability concerns that have so far plagued the non-core countries will migrate to the core, pushing up bond yields in the likes of Germany and France. 

Moral hazard might increase fiscal profligacy: More generally, with the establishment of a potentially large stabilisation fund, fiscal policy in the euro area is being effectively socialised. No country will be allowed to fail, and it seems that no country will be too big to bail. Ultimately, this creates an incentive for governments to run a looser policy than otherwise.  If markets then refuse to fund a profligate government, it could turn to the fund, borrow at below-market interest rates and domestically blame the required fiscal tightening on the ‘diktat' from the euro area partners and the IMF.  So, our bottom line on the implications of the European fiscal emergency plan is that, while it addresses the near-term liquidity problems, it does little to solve the underlying problem of fiscal sustainability and may even make things worse on this front over the medium term.

The ‘Fed-eralisation' of the ECB: Turning to monetary policy, the events of the last several weeks, when the ECB had to make an embarrassing climb-down on the collateral rules for Greece, plus the new measures announced this past weekend, suggest that ECB policy is being increasingly politicised, in our view, which hurts the central bank's credibility. The decision to buy government (and potentially private sector) bonds in "dysfunctional" markets, which the ECB and the NCBs have begun to do in size this week, was a big step for the ECB. While these purchases in the secondary market do not violate the letter of the Maastricht Treaty, which rules out direct lending to governments or bond purchases at auction, they clearly help governments finance their deficits at lower rates than otherwise. Moreover, we have severe doubts about the effectiveness of the intended ‘sterilisation' of these purchases. Technically, the ECB could sterilise the impact of the bond purchases on bank reserves by selling bills or other bonds against them. However, with full allotment at the ECB's refi operations, the banking sector rather the ECB ultimately determines the size of their reserves and of the ECB's balance sheet.  So, it is up to the banks rather than the ECB to decide whether sterilisation will be effective or not.   

Fed super-easy for longer: Another implication of Europe's sovereign risk crisis is that it has depressed US bond yields due to safe-haven flows and has pushed market-implied inflation expectations lower as well.  As a consequence, our US economics team now sees US official interest rates on hold well into next year, despite an upward revision of our GDP growth forecasts (see Sovereign Credit Risk Means a Lower Path for US Rates, May 10, 2010).  Thus, both European and US monetary policy now look set to remain easier for longer, trying to offset the implicit tightening of financial conditions due to funding pressures on banks emanating from the sovereign crisis.

More inflationary global policy stance: Importantly, from a global perspective, lower US and European rates for longer are likely to add fuel to the powerful economic rebound in many EM economies.  This is because the authorities there are trying to prevent or slow exchange rate appreciation vis-à-vis the US dollar or the euro.  Lower dollar or euro rates for longer are likely to lead to even more capital inflows into EM, which make it difficult to tighten monetary policy (see "Living with the Trilemma", The Global Monetary Analyst, January 20, 2010).  As a consequence, the global monetary policy stance is likely to remain very easy for longer, and excess liquidity (measured by the ratio of money supply M1 in the hands of non-banks relative to nominal GDP), which has been sky-rocketing for about a year now is likely to increase further.  Thus, the sovereign risk crisis in Europe, through its expansionary effect on the global monetary stance, further accentuates the gap between EM and DM growth, supports a continuation of liquidity-driven rallies in risky assets, and raises global inflation pressure. 

Debtflation temptation playing out: To sum up, contrary to the consensus, we view the intensification of sovereign risk concerns as adding to medium-term global inflationary risks because central banks are increasingly being forced to maintain their super-expansionary policy stance.  Thus, what we have called the ‘Debtflation Temptation', i.e., the temptation to inflate away mounting public sector debt, appears to have become irresistible.     

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