balancing act between the need to engineer a one-size-fits-all monetary policy and safeguard
financial stability in the area. To make things even more complicated, it seems increasingly
likely that the central bank will not get much help from European politicians, currently unable
not only to deliver the “quantum leap” asked by Trichet, but also to speak to nervous financial
markets with one, credible, voice. These are the main themes for next year.
We stick to our forecast of a first refi rate hike at end-2011…
Despite recent acute tensions in peripheral countries, we don’t surrender to the temptation
of delaying sine die the beginning of the tightening cycle. Three crucial assumptions
stand behind our refi rate forecast: 1) contagion will not destabilize Spain; 2) ECB monetary
policy will continue to be calibrated for the eurozone as a whole; 3) the ECB’s reaction
function did not change dramatically due to the sovereign debt crisis. If these assumptions
hold, our rate call can reasonably be expected to remain linked to developments in euro area
fundamentals, and the most important question to ask ourselves is how our baseline CPI/GDP
scenario and the balance of risks moved in the last few months. The answer is the following:
■ Our central projections have shifted slightly higher, both for CPI and GDP;
■ Risks remain balanced for GDP – surprisingly strong business surveys up to November
offset the heightened, although still very small, risk of a disruptive tail event – and have
moved to the upside for CPI.
Monetary stance: slightly more accommodative than three months ago
As we show in the European Economist section, domestic demand fundamentals at the areawide level continue to move in the right direction and increasingly support the view of a
recovery that is gaining sustainability, while the softening in global growth has proved less
pronounced than feared. Moreover, although the CPI outlook remains favorable, the “revision
drift” – which captures the prevailing direction of forecast changes – is now pointing upwards,
and so does the balance of risks (see the Inflation Watch section). If anything, the economic
analysis applied to our own forecasts – which however are very similar to the ECB’s –
suggests that the current refi rate level has become slightly more accommodative than
three months ago. This result is also confirmed by the monetary analysis, which indicates a
steady acceleration in lending to the private sector (although at 1.4% the growth rate is still
anemic) and the formation of a bottom in corporate loans, usually the last component to turn
in the lending cycle. Our Taylor Rule, which links the level of the refi rate to a survey-based
measure of output gap and the growth rate of lending to the private sector, continues to show
a slow but steady upward drift in the “fair” level of the policy rate, now seen at 1.10%.
Put simply, not only don’t economic fundamentals support a change of our rate call; they also
tell us that all the conditions to see a higher policy rate in one year’s time remain in
place. One last thought on the ECB’s 2012 CPI projection at 1.5%. Per se, this forecast is
inconsistent with a rate hike at any time through the whole forecast horizon. However, we
think that this number is way too low: given that core inflation is currently at 1.1% and the
ECB expects it to accelerate moderately further (see the November ECB Bulletin), the central
bank must have included into its baseline scenario overly conservative numbers for food and
energy inflation. It is very likely that the ECB will revise this forecast higher as 2011
progresses and we expect it to eventually converge towards our 2.0% estimate.
Exit strategy is delayed
However, it is clear that at this stage the market is focusing on the weak links of the eurozone
chain, and improving area-wide economic fundamentals don’t provide enough reassurance to
investors that nasty tail events can be ruled out. On 2 December, in response to renewed
tensions in the money market and significant spread widening in the periphery, the ECB
decided to delay the withdrawal of emergency liquidity measures. In 1Q 2011 the central bank
will hold three more 3M LTROs with full-allotment at a rate fixed at the average rate of the
MROs over the life of the respective LTRO. Moreover, fixed-rate, full-allotment will be retained
for 1W MROs and 1M LTROs at least throughout 1Q 2011. In practice, the exit strategy is on
hold for another quarter, if not longer, despite a more hawkish set of macroeconomic
projections. This confirms once again that in the ECB’s policy framework the liquidity
strategy and standard tools remain independent of each other. The timing of the exit from
non-standard liquidity provision will depend crucially on how market tensions evolve from
here, and any call is subject to huge uncertainty. In our baseline scenario, Portugal will need
to tap EU/IMF funds relatively soon (probably very early in 2011), but contagion will not
extend to Spain in light of improving macroeconomic fundamentals, a credible fiscal policy
and a banking sector which we deem less vulnerable than generally thought. If we are right on
this point, we see good chances that market pressures will ease from the spring onwards,
helped also by the new (more demanding) round of area-wide bank stress tests, presumably
due for publication around the end of 1Q 2011. The ECB should then be able to announce the
resumption of its exit strategy at the June meeting and discontinue the full-allotment at the 3M
tenor starting in July, although it’s obvious that the central bank will be quick to exploit any
window of opportunity provided by a faster-than-expected normalization to exit sooner. In any
case, recent events suggest that it will take longer than previously thought before we see the
banking sector of peripheral countries reducing the reliance on ECB funds. Accordingly, we
now think that the ECB will err on the side of caution and continue to provide unlimited
liquidity throughout next year, and possibly beyond. The first increase of the refi rate at
end-2011 should therefore come with full-allotment still in place, although probably
only for weekly MROs.
ECB govie purchases: in the near term, the main line of defense
On 2 December, Trichet showed that the ECB’s attitude towards the SMP (Securities Markets
Program) has not changed meaningfully due to recent tensions. In particular, he refrained
from providing any numerical target for potential government bond purchases, but we read the
commitment to be “permanently alert” as a clear signal that the central bank will deploy all
feasible tools at its disposal to preserve financial stability in the area. After all, the ECB is
perfectly aware that its purchases are the main line of defense against near-term
contagion fears, because European politicians currently are doing more harm than good with
their lack of consensus on how to pave the way out of the crisis. However, despite having
considerable firepower, the ECB will as much as possible try to avoid being pulled into
large-scale purchases (which we define as tens of billions a week for several weeks), due to
a number of problems that any such action would imply. First, it risks making the GC divide
more troubling, with chances that other Council members will eventually join Weber in the
camp of those who openly call for an end of the program. This would be very damaging for
the ECB’s credibility and, in turn, its capability to stabilize market sentiment. Second, it risks
generating dangerous political repercussions among virtuous eurozone countries, which could
increasingly perceive the ECB action as aimed at monetizing the debt of profligate countries.
This would undermine the credibility and effectiveness of government bond purchases. Third,
risk management considerations argue against a bold move, given that massive buying would
affect noticeably the riskiness of the central bank’s balance sheet. Fourth, full sterilization of
the purchases would become problematic, with potentially negative implications for inflation
expectations.
No numerical target for the SMP
The bottom line is that, before entering the market in full force, the ECB will want to see that
rising tensions in peripheral countries lead to potentially severe implications for the euro area
as a whole. As can be seen from our Financial Market Index (FMI), which measures broad
financial market conditions in the eurozone, on the eve of the 2 December ECB meeting the
degree of market disruption was certainly not sufficient to justify a bold move by the ECB.
However, even if market conditions eventually were to force the central bank to embark on
large-scale intervention – which most likely would mean buying also Spanish government
bonds – we doubt that the ECB will ever come up with an official purchase target. A
large numerical target looks plausible (and effective) only in case of full-blown quantitative
easing. But this is a completely different story.
BoE – More QE is unlikely
2011 will be the year when the fiscal tightening outlined in the June Emergency Budget and
better detailed in the Spending Review later in October will start to bite. The question remains
whether the solid economic recovery currently underway will eventually be derailed by a very
severe fiscal consolidation effort. Needless to say, another important factor which might affect
the macroeconomic outlook will be the evolution of the sovereign debt crisis in the eurozone,
as it is difficult to imagine the UK economy escaping the negative impact of an escalation of
financial market tensions in the eurozone. However, in our baseline scenario, the sovereign
debt crisis is unlikely to get out of control, with Portugal seen tapping EU/IMF funds relatively
soon (probably very in early 2011), but Spain avoiding contagion. We see therefore market
pressures abating from the spring onwards, with the contagion from the sovereign debt
crisis being only a tail risk in our macroeconomic scenario for the UK.
Having said that, here we will mostly focus on how we expect the economy to face the
headwind from the fiscal squeeze. Our baseline scenario sees a continuation of the
ongoing recovery, albeit at a slower pace than seen so far this year. We expect GDP to
grow by 1.8% and 2.0% yoy this year and the next. Our relatively constructive view on next
year’s growth prospects relies on two factors: 1) improving fundamentals will continue to
support the ongoing recovery in capex; 2) net exports should continue to add a positive
contribution to GDP growth, at least throughout the first half of next year.
Starting with the latter, after having subtracted from GDP growth in the previous four quarters,
the net exports contribution turned positive (+0.4pp) in 3Q this year, as export growth
outpaced by far imports. The question is whether such a strong performance might be
sustainable in coming quarters. Our view is that net exports will continue to add a
positive, albeit more contained contribution to GDP for most of next year. On the one
hand, given the lag with which currency movements affect exports, we think that past sterling
depreciation will continue to underpin export growth in coming quarters. Still, some
moderation is in the cards, given the ongoing slowdown in global growth and, more
importantly, in some of the largest UK trading partners (namely the US, which accounts for
17% of total UK exports, and Ireland, which accounts for 6%). On the other hand, we expect
import growth to remain subdued, as the inventories-related boost should wane.
Looking at the dynamics of domestic demand, the most important driver is likely to come from
capex. There are several factors which should underpin the ongoing recovery. First of all, it is
worth noting that the UK corporate sector is in relatively good shape, continuing to benefit
from a structurally positive financing gap – an indicator of the corporate sector’s ability to
finance investments via internally-generated funds. Moreover, over the last year and half the
financial surplus has improved further, rising to 5.4% in 2Q 2010 from 1.3% in 3Q 2008. This
was due to the dramatic plunge in investments during the recession, but also to firms’ raising
gross savings, in the wake of falling interest expenses and the improving trend in corporate
sector profits. On the latter, in particular, it is encouraging to see that, while still in contraction
territory, some recovery is underway: after having reached the bottom at around 11% yoy in
4Q 2009, the contraction in gross profits eased to around -3% yoy in 2Q 2010. The fact
that the corporate sector is currently enjoying a solid cash buffer to finance future investments
is a positive factor, which should offset, at least partially, persistently tight credit conditions.
Still, another indication which supports our relatively optimistic investment outlook comes
from business survey measures of capacity utilization. After having collapsed during the
recession, the margin of spare capacity seems to have narrowed since the beginning of
the recovery, albeit some remains. In particular, capacity utilization seems to have increased
faster in the manufacturing sector – where it is back in line or above its long-term average -
than in services. This suggests that firms, particularly in the more capital-intensive
manufacturing sector, might be willing to expand their production capacity in coming quarters.
This is confirmed by the generalized improvement in survey-based measures of investment
intentions, which are back to and, in some cases, above their pre-crisis average. That being
said, one note of caution needs to be made: both net exports and capex will only partially
offset sluggish private consumption and slowdown in construction investment. While
the latter should be negatively affected by renewed housing market weakness, households’
spending will likely suffer more directly from the fiscal consolidation, via lower income
prospects due to both the pay freeze and reduction in employment in the public sector.
Overall, despite these two caveats and looming downside risks, our central growth scenario is
one of a continuing economic recovery. Against this backdrop, and taking into account a
relatively unfavorable inflation scenario, we see very low chances that the BoE might resume
its quantitative easing program next year. Coming to our CPI projections, we expect the
disinflation trend, which will eventually materialize throughout next year, to be very slow: after
having averaged 3.2% this year, we expect only a modest deceleration to around 2.9% in
2011. Core inflation should ease next year but only in the second half of the year, and the
downside is likely to be limited. On the one hand, the increase in the VAT in January 2011 will
add some upward pressure on core prices; on the other hand, the output gap should
eventually start to exert some downward pressure on the core index. However, both the
extent and timing remain highly uncertain: we would, indeed, have expected to see the
impact of the huge widening in the margin of spare capacity on core prices already at the
beginning of this year. On the contrary, core inflation accelerated, casting some doubts on
whether the usual transmission mechanism is still working or on whether the recession might
have reduced the supply potential of the economy to the extent that the degree of spare
capacity is much lower than generally thought. Moreover, it is very likely that for most of 2010
the economy has run above potential, contributing to partially narrow the output gap. Even
assuming that next year the economy might settle again below potential, the renewed, likely
limited, widening of the output gap is unlikely to be felt before the middle of 2012. Bottom line:
there is limited room next year for a significant downward adjustment in core inflation, which
now stands at the very high and uncomfortable level of 2.7%. As a result, taking into account
the upward pressure coming also from food prices and some upside risks related to energy
inflation, we expect headline inflation to hover around 3% from most of 2011. Against this
backdrop, the BoE is unlikely to resume its quantitative easing program after seeing
signals of a growth slowdown in the first half of 2011. The risk of jeopardizing its credibility,
bringing a dangerous spike in inflation expectations, is indeed very high. At the margin, risks
are rather skewed towards a later start of the tightening cycle than we are currently
penciling in (4Q 2011), should GDP growth not show signs of revival in 2H 2011.
SNB – Necessary easing of tensions has yet to happen
The Swiss economy continued its V-shaped recovery in the summer. The GDP dynamic in 3Q
was only slightly softer than before mid-year. The solid performance was driven by domestic
demand. In contrast, exports contracted a strong 3.0% qoq, but we don’t think that CHF
strength has "stalled" the export sector. Business surveys show that currency appreciation
is clearly a competitive disadvantage in many manufacturing areas, but the current
assessment remains astonishingly resilient. Even the SNB admitted that it is positively
surprised how limited the impact has been. At least for the time being, the strength of
global demand keeps the outlook for Swiss exporters rather positive. Production plans
of export-oriented firms even improved further at the beginning of the final quarter. Hence, not
surprisingly, monthly export figures showed a jump of 6.2% in October, strongly increasing the
odds for a substantial positive GDP contribution of net exports in 4Q10 again.
Accordingly, the conditions for an ongoing improvement in domestic demand also look
favorable. The rapid recovery in capacity utilization rates argues for strengthening
investment demand. In addition, private consumption can be expected to remain a
reliable growth pillar. The consumer climate has softened recently, but continuing net
immigration and above all the upward trend on the labor market support disposable incomes.
Moreover, the strong CHF improves the purchasing power of households. And although
households have to digest a modest VAT hike and higher social security contributions, the
excellent fiscal situation of the public sector helps to avoid a severe fiscal drag. The solid
position of the household sector is also reflected in the housing market. Prices for singlefamily homes were up a strong 5.0% yoy in the third quarter. Although there are no
alarming signs of a general price bubble, “affordability” is heavily supported by the
record-low interest rate levels. Over the medium term, overly lax lending can cause severe
problems in the financial system. But although developments in the mortgage market continue
to require the full attention of the SNB, the central bankers favor moral suasion and
stricter regulation instead of using interest rate policy to tackle the problem.
Consequently, Swiss monetary policy remains extremely focused on external developments.
Fears of a global double-dip recession have diminished of late. But the piecemeal approach
of EMU politicians in respect to the debt crisis, without any comprehensive resolution
in sight, keeps demand for safe-haven currencies high. According to our estimates, due
to the strong CHF appreciation, the very low target rate remains appropriate, despite the Vshaped upswing. And in the current environment, an early rate move would still likely trigger
an undesired monetary policy tightening via further CHF strength. As the latest conditional
inflation projections of the SNB even see the possibility of temporary deflation at the
beginning of next year, the central bank is not under immediate pressure to start interest rate
normalization. In any case, external conditions can change very quickly, and a sustained
easing in EMU tensions would give the SNB more room for maneuver again. However,
considering the latest events, the odds for a first SNB hike later than in March 2011
have clearly increased of late.
http://www.unicreditmib.eu/
Full report: The ECB Outlook 2011 : A challenging year
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