by HVB Group Global Markets Research
HVB Group
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Bail-out. Were it not for the billions in aid from the Treasury and the Fed, it is quite possible that the US financial system would have already collapsed. Nevertheless, they could not prevent the failure of individual financial institutions as well as an economic growth slowdown.
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Tax checks. The financial crisis combined with a weaker labor market as well as high oil prices already led to falling real compensation of employees. Without the tax rebates, private consumption would have already plunged into negative territory and the US economy into recession. The tax rebates are still providing support, but the economy is expected to do little more than stagnate by year-end 2008 (pages 7-9).
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Hope. And it is questionable whether the recent rapid inventory rundown can prevent further production cuts and can push the growth trend north next year. Calls for a new fiscal package are, therefore, becoming progressively louder. But even then, US growth will remain well below potential in 2009 (pages 5-6).
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Monetary policy. For that reason, the Fed would retain its accommodative policy also next year – were it not for the high inflation and the fear of rising inflation expectations, which would require even stronger counter-inflationary measures later. The Fed will, therefore, exploit initial signs of labor market stabilization to start to reverse its expansionary monetary policy – but definitely not before the end of this year.
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Further topics:
– Weekly Comment: Surprised? Me? (page 2).
– Germany: Industrial production heading for stagnation (page 10).
– Bank of England faces a major challenge (page 13)
– Data outlook: Eurozone economy has contracted (page 15).
– Market outlook: USD to post further gains; Bunds to move sideways (page 23).
Surprised? Me?
Trichet’s press conference yesterday confirmed that the window of opportunity for further rate hikes has been slammed shut by the cold blast of negative data releases that swept through the eurozone in the last few weeks. Rate hikes have been priced out, and the real question is how long the ECB can lean against the wind before the market starts pricing in rate cuts – my guess is another 2-3 months at the maximum. While the ECB has “no bias”, the macro data have a clear downward bias that leaves little doubt on the direction of the next policy move. Yesterday’s press conference also confirms that the golden age of the euro has probably come to an end, and that conditions are in place for a recovery of the USD over the remainder of the year. In this regard, Bernanke’s and Trichet’s positions this week were reassuringly consistent (unlike in June), and this should also favor a consolidation of the recent commodity price correction. The ECB yesterday acknowledged that the weakening of growth evident in the latest data is only partly a technical correction from an unusually strong Q1, and that some of the longnoted downside risks to growth have started to materialize. In particular, in both the statement and the Q&A, Trichet pointed to a weakening in the global economy and to the adverse impact of high commodity prices. The statement notes that growth in “mid-2008” will be “substantially weaker” than in Q1, and the sum up paragraph dropped the reference to “moderate ongoing real GDP growth”, which would sound inaccurate for an economy which seems to have hit a wall in Q2. In September, the revised staff forecasts will likely show a significantly less rosy outlook. We have been arguing for a long time that the eurozone would face a steeper downturn than the ECB seemed to anticipate, and the recent data have brought strong support to our position: our proprietary indicators, the composite PMI and the GDP tracker (cf. chart) are pointing to a very significant loss of momentum.Q2 is very likely to be in negative territory, raising an outside risk of a technical recession.
The eurozone is not an island. We had already seen a fullfledged financial contagion from the subprime crisis, and recent data have shown that the real economy is also being hit. Previous ECB assessments had placed a significant bet on decoupling, arguing that buoyant emerging markets would support global growth and therefore external demand. Yesterday, instead the bank blamed in part the global slowdown for the unexpectedly sharp downturn in eurozone growth. The data vindicate the analysis in the latest IMF report, which shows that the interdependence between the eurozone and the US is high and has increased over time and that growth slowdowns are highly synchronized, with both the trade and the financial channel becoming stronger. As a rough rule of thumb, the IMF finds that a 1pp decline in US GDP growth leads to a ½ pp decline in eurozone growth after one year. Given the lag, the ongoing slump in the US poses a continuing threat to the eurozone’s growth outlook.
Trichet mounted an awkward defense of the ECB’s position, arguing that the bank had not been surprised by recent developments because they were just the materialization of risks that it had identified and mentioned for several months. I do believe the ECB honestly saw its baseline scenario as the most likely. Ex-post, however, this defense sounds disingenuous. The IMF staff report published a few days ago noted a simple difference between the IMF’s growth forecasts and those of the ECB: the IMF forecasts lower growth with symmetric risks, whereas the ECB forecasts higher growth with risks skewed to the downside – ex post, it is easy to argue that the ECB’s scenario was too sanguine. Moreover, while the ECB may not have been surprised by the sudden downturn in the data, it did not seem to have provisioned for it – July’s rate hike was presumably decided on the assumption that downside risks would not materialize.
Trichet also defended up-front the decision to hike rates last month, arguing that it had been vindicated by the information that has become available since the last meeting. As my colleague Aurelio Maccario very aptly noted in his note earlier yesterday, excusatio non petita, accusatio manifesta: the prominent and unprompted defense of last month’s hike gave very much the impression that the ECB felt accused of having tightened policy in the face of an already slowing growth momentum. The case for the prosecution is indeed quite strong: since the onset of the crisis, monetary and financial conditions in the eurozone had tightened substantially (cf. chart on the following page). The case for monetary tightening was far from obvious, and the IMF had noted that it saw no compelling case for tougher monetary policy. Pressed during the Q&A, Trichet was unable to come up with a more precise list of the evidence that had ex-post validated the hike.
That is probably understandable. I have argued that in my view July’s hike was a pre-emptive strike aimed at avoiding widespread second round effects and at anchoring inflation expectations. If that is the case, then the vindicating evidence is largely counterfactual, namely that broader second round effects have not materialized, and that inflation expectations have not risen further. On the latter point, though, in my view inflation expectations seem to have reacted more to the recent correction in oil prices than to the ECB’s hike.
Trichet was put on the spot when asked whether he shared the view expressed by one Council member that the growth slowdown would not cool inflation pressure, and whether the ECB was ignoring the fact that a downturn would eventually exert deflationary pressures. Trichet replied that the ECB took into account all factors that could influence inflation, the “only needle in the compass”, but did not offer a convincing rebuttal to the implicit charge that the bank might be underestimating future deflationary pressures.
The ECB was very careful in stressing that it is not lowering its guard against inflation – second round effects are still public enemy number one. The statement repeats the assessment that upside risks to price stability have increased further. This sounds at odds with the slowdown in growth and the correction in commodity prices, but Trichet clarified that past commodity price increases have caused significant pressure that is still in the pipeline. Moreover, Trichet noted that the ECB is monitoring not only wages but wage and price-setting at large, and is equally concerned about potential price dynamics in sectors where competition is weaker. This might reflect the fact that the ECB has perceived that in some goods and services sectors price-setters might be tempted to raise prices to recover margins eroded by higher input costs. Compared to previous meetings, the emphasis has switched a bit away from wage negotiations and to a broader assessment of price-setting trends in the economy.
As another hawkish caveat, Trichet noted en passant that the commodity price shock we have experienced could have reduced the eurozone’s potential growth rate. If that were the case, then a given slowdown would be less effective in reducing inflation. Pressed on the issue in the Q&A, Trichet said the ECB had not yet come up with a new estimate of potential output growth. Overall, however, I would take this as a further indication that the ECB is still gathering all the arguments that could still support the need for a tight monetary stance.
The credit tightening conundrum was on the table again, pending the release of the new Bank Lending Survey. The ECB stands by its assessment that the expansion of bank credit to non-financial corporations has not been significantly affected by the crisis. Trichet acknowledged that consumer credit and mortgages have decelerated significantly, contributing to some loss of momentum in credit overall. The ECB’s overall assessment, however, remains that credit supply is not likely to be a constraint to growth, although it does expect loan demand to decelerate in line with GDP. The IMF believes there will be a credit supply effect, but not a massive one: it has estimated that the deterioration in bank soundness observed to date in the eurozone could cause a 0.3pp decline in GDP growth with a 6-quarter delay, with the risk of a stronger impact to the extent that non-eurozone banks (UK, Swiss), more affected by the financial crisis, play a role in eurozone credit creation. In this regard, the IMF also noted that corporate balance sheets are healthy and there is no investment overhang, but that European companies are more leveraged and more reliant on bank credit than in the US.
The golden days of the euro are over. Markets have realized that the economic slowdown is now migrating or spreading from the US to the rest of the world, and the eurozone is already being hit. It seems increasingly likely that the next policy rate moves will be a cut in the eurozone and a hike in the US – although the timing on both is still very uncertain. With the rate differential set to narrow, and faith in the resilience of the European economy crumbling, EUR-USD should continue its correction (cf. chart next page) over the remainder of the year. This should be good news for all concerned. First, the strengthening of the euro has become a significant headwind for eurozone growth. The IMF estimates that the EUR is overvalued by at least some 10%, and this is allowing for a significant gain in competitiveness, as the REER is 15% stronger than the 1993-2006 average. The 10% estimate, according to the IMF report, is broadly shared by EC and ECB, with some European officials expressing significant concern about the possible impact of the appreciation on medium-term growth prospects. Second, as I have argued in the past, a declining EUR-USD strengthens the chances that the recent correction in oil prices will continue or at least consolidate. In this regard, Bernanke’s and Trichet’s positions this week were reassuringly consistent, unlike in June.
Communication, accountability and legitimacy. In a recent piece with my colleagues Aurelio Maccario and Davide Stroppa, I have argued that the ECB’s communication strategy faces significantly harder challenges now than in the past. Yesterday’s press conference confirmed this, with the ECB visibly on the defensive. My impression yesterday was that the publication of the minutes could indeed be a useful way to cast more light on the way that the Council members are weighing some of the issues raised in the Q&A – but this is a separate and more complex topic.
Bottom line: The window of opportunity for further rate hikes is now closed, and we still expect the next move will be a cut delivered most likely in Q2 next year. The more interesting question is how soon the markets will start pricing in an easing cycle. From what we heard yesterday, I expect the ECB to lean heavily against the wind, trying to prevent rate cut expectations from arising before there is convincing evidence that headline inflation is decelerating and that core inflation has remained stable. It will be another serious communication challenge. I would expect markets to start pricing in cuts by year-end.
source : www.fxstreet.com
