US
The call for Federal Reserve rate hikes grew louder this week. In testimony to Congress on Wednesday, Fed chairwoman Yellen noted that the next FOMC meeting in December is a “live possibility” for interest rate hikes. On Friday, a resounding jobs report that showed the economy created 271k jobs in October added a jolt of electricity to just how “live” it is.
With worries about a slowdown in job growth put aside, the response in financial markets was unsurprising. Rates rose across the yield curve and the probability of a December hike, as priced by futures markets, rose to above 70%. This is a substantial reversal from the generally downward trend through most of October.
The breadth of evidence in the data this week suggests that the American economy is continuing to grow above trend and slack in the labor market is continuing to diminish. Earlier in the week the ISM reports showed the source of ongoing strength is the domestic-based economy, while the sore spot is still the globally-exposed export sector. This is not new. What is new is the growing body of evidence that the latter will not bring down the former. This was further corroborated in the payrolls report. Manufacturing employment was flat in the month, but this was more than made up for by strength in construction (+31k) and private service industries (+241k).
In weighing just how strong job growth is, it was noted then that while the weak number may suggest a role for global headwinds, structural issues were also at play. As economic slack diminishes, expectations for job growth should be revised lower on a trend basis. Given the growing number of baby boomers leaving the workforce for retirement, the level of job growth necessary to keep the unemployment rate from moving higher is just 100k a month.
This is still important context. Job growth of 271k is miles away from this neutral trend. The debate at this point may come back to two points. First, the unemployment rate at 5.0% may not be capturing the full level of labor market slack. There are a lot of people who have not left the labor market to enjoy their golden years, but rather because they have simply been unsuccessful in finding work. This is true, but it does not negate the fact that this “shadow slack” is also diminishing rapidly. In fact, the broadest measure of labor market slack, the so-called U6 rate, which adds marginally attached workers (people who want a job, but are not currently looking) and those employed part-time for economic reasons, fell 0.2 percentage points to 9.8%.
A second point is that if conditions in the labor market are so robust, why then aren’t we seeing stronger wage growth? This too is becoming increasingly less valid. Average hourly earnings rose a robust 0.4% in October and accelerated to 2.5% on a year-ago basis, the fastest growth in over six years. Given the low level of inflation, this represents real gains in labor income that will continue to support consumer spending going forward. This is all the Fed needs to see to begin a gradual tightening in monetary policy, which is likely to begin at the December meeting.
From another angle, though, gauging the pulse of the US economy has been made more complicated this year by the volatility of the quarterly national accounts data. In the first estimate for Q3 (which will almost certainly be revised over subsequent quarters), GDP increased at a 1.5% annualised rate, but that followed a 3.9% outturn in Q2, 0.6% in Q1, 2.1% in Q4 2014 and 4.3% in Q3 2014. In these circumstances, the best it can be done is smooth through the volatility by focusing on the year-on-year (y/y) growth rate. That came in at a tick over 2% in Q3, little different from its post-crisis trend. 2% growth is certainly disappointing compared to previous business cycle recoveries but, as evidenced by the substantial improvement in labour market conditions in recent years, it has probably been above the economy’s potential growth rate over the period. If policymakers want to see growth sustained at a meaningfully higher rate, they will need to put in place reforms to lift labour force participation rates and productivity growth.
Although headline growth in Q3 was disappointing, the underlying details were more positive. A rapid slowdown in inventory accumulation during the quarter subtracted 1.4 percentage points from growth, as firms reacted to the overhang that had developed over previous quarters. Inventory levels now look to be more closely aligned with the underlying growth rate of domestic demand. Elsewhere, the vast majority of growth in the quarter was accounted for by strong personal spending, as consumers continued to spend the bounty provided by lower oil prices. Business investment outlay, on the other hand, was subdued. Although investment in new equipment grew at a 5.3% annualised rate in the quarter, investment in non-residential structures fell, while investment in intellectual property products was much weaker than its recent trend. Meanwhile, net exports were flat in the quarter, as the drop in inventories also weighed on import growth, offsetting the tepid growth rate of exports. Looking forward, the expectation for growth is to settle in a 2-2.5% range, with solid domestic demand growth partially offset by modest declines in net exports due to lagged effects of the strong dollar and still-weak economic conditions in emerging markets.
Against this backdrop, markets were caught off guard by the perceived hawkishness of last week’s Federal Open Market Committee statement from its October meeting. Two aspects of the statement caused surprise:
The first was the removal of the previously cited concern that “global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation”.
The second was the addition of a new phrase around the timing of the first rate increase that made it clear that a December move is still on the table. In hindsight, investors should not have been surprised. Since the September meeting, financial market volatility has declined, while the trade-weighted dollar has stabilised.
Meanwhile, the probability of a government shutdown has receded and growth is consistent with further labour market improvement. Committee doves may not be convinced this is enough to be sure that inflation is moving back to target but Yellen appears to still believe in the Phillips Curve. The upshot is that if the next two employment reports are healthy and domestic demand growth holds up, the Fed could surprise by raising rates for the first time since 2006.
EU
For many months, ECB representatives categorically ruled out a further key interest rate cut but a reduction of the deposit rate is now en vogue again. According to ECB chief economist Praet there are no taboos when it comes to monetary policy instruments, while his executive board colleague Coeuré said in the context of a deposit rate cut that a discussion had begun but the outcome was open.
That said, the ECB will also be aware that cutting the deposit rate further (it is currently at -0.2%) could actually do more harm than good. Monetary policy measures normally only have an effect on economic growth and prices with a substantial delay. A short-term effect only occurs via a signal effect, meaning that a central bank can influence exchange rates and yields merely by announcing measures. The ECB is therefore likely to select the tool with which it can send the strongest possible signal and thereby put pressure on the euro – which would have a rapid positive effect on inflation.
However, it is unlikely to achieve this by cutting the deposit rate in isolation for several reasons:
- The biggest risk arising from a rate cut would be if it gave markets the impression that the ECB is doing this because it now has doubts about the success of the asset purchase programme. This would give the overriding impression that the ECB had launched one final desperate attack. Part of the signal effect of an expansionary measure results from the fact that it creates hopes on the market of further steps. However, the ECB deposit rate is already negative at -0.2% and the scope for further rate cuts is undoubtedly limited. Therefore, hopes of another cut in the deposit rate are unlikely to be strengthened by a single reduction. Instead, it is likely to affirm the view that the ECB has shot all its powder for this instrument.
- A reduction in the deposit rate contradicts the ECB’s repeated statement in past months that the lower limit for key interest rates has been reached. Admittedly, the rate cut as such would be welcomed by the market – like any other additional expansionary measure – but the credibility of the central bank would suffer. In particular in the current situation, the success of ECB measures depends not least on market confidence that the ECB stands by the statements it has made and implements the measures as announced. For this reason, ECB Governing Council member Ardo Hansson has therefore already made up his mind: he has rejected a lower deposit rate because this would contradict previous forward guidance issued by the ECB.
- An isolated cut would therefore send out only a weak signal to the financial markets, and the direct effect in lowering the euro exchange rate would be minimal. Also, a cut in the deposit rate would increase inflation only slightly in the medium term. This is clear from the ECB’s “euro area wide model”, (AWM), which staff developed specifically for forecasting and simulating policies.
According to this model, a 50-basis-point cut1 compared to the baseline scenario would lead to a 0.1 and 0.2 per cent rise in the consumer price index on a one and three year horizon respectively Consequently, the inflation rate would be a mere 0.1 percentage points higher in the coming years if the ECB were to fully exploit the scope it has to cut rates. And this figure is presumably still too high as it assumes that other central banks sit tight, which is unlikely based on the experience of previous months. Numerous central banks will respond to such a move by the ECB with similar expansionary steps and the euro will presumably depreciate to a lesser degree than the ECB model simulations suggest. According to an OECD study, the consumer price index three years after a 50 basis point ECB rate cut would be only 0.05 per cent higher if exchange rates in the model simulation are kept constant.
Another argument against an even lower deposit rate is that lending rates in the euro zone could increase. Mortgage rates in Switzerland, for example, rose after the SNB’s sharp rate cut from -0.25% to -0.75% in January. SNB Vice President Zurbrügg recently explained how this apparently unusual development occurred4: Unlike in an environment with positive interest rates, banks hesitate to pass on falling money market rates to the holders of fixed-term and savings deposits when rates are negative. This is because a negative rate for these types of deposits might result in many customers viewing cash holdings as an attractive alternative to bank deposits and therefore withdraw their money, in which case an important refinancing source for banks would dry up. To prevent this, banks are foregoing lower deposit rates and are increasing lending rates instead.
To sum up, an isolated cut in the key interest rate will not sent out a clear signal to the financial markets; it will barely increase inflation in the medium term and could even lead to higher rather than lower lending rates. Therefore, the package of measures is unlikely to be decided by the ECB in early December to consist primarily of a cut in the deposit rate. Instead, the ECB is likely to focus mainly on increasing the volume of monthly purchases, as this is the only way to make monetary policy more expansive immediately. In addition, it will probably no longer mention an end point for the purchases and thus confirm its promise of a very expansionary monetary policy for a long time to come. It will justify these additional measures by stating its view that inflation will take far longer than previously expected to approach the target figure of just under 2%.
However, it is quite possible that the ECB regards lower deposit rates as a way of increasing the effectiveness of bond purchases. The central bank has said that it would only buy bonds whose yields are above the deposit rate. Consequently, if the yields of many bonds fall under this mark, it would become increasingly difficult for the ECB to find enough assets to purchase. If this appears to be the case, the ECB will be more likely to lower the deposit rate again.
Whether a rate cut will be part of the package of measures therefore probably depends on the central bank’s assessment of scarcity in the asset purchase programme. It is not easy to estimate this as the central bank usually denies for tactical reasons that there are any problems here. The possibility that the ECB will also marginally reduce the deposit rate to prevent shortage problems cannot be ruled out – in addition to the already decided increase in the percentage upper limit at which it acquires bond issues and the anticipated broadening of purchases to other asset classes such as corporate bonds.
That said, it is somewhat more likely that the ECB will keep its powder dry with regard to the deposit rate; the Fed’s turnaround on rates should reduce the shortage problems so the ECB will get help from outside. The Fed is expected to make its first interest rate hike in December. International investors should be all the more ready to sell euro bonds as more attractive investment opportunities materialise outside the euro zone. And US Treasury yields should rise all the faster, i.e. become more attractive, the faster the Fed raises interest rates compared to current market expectations. Since most baseline scenarios incorporates a relatively rapid pace of Fed rate hikes, investors will probably also be more willing to sell euro bonds. In such a case, the higher monthly purchase volumes should be less of a problem.
UK
Recent survey data shows that the economy continues to grow at a solid pace. The Purchasing Managers’ Indices, PMI, for all sectors were reported this week. The PMI for the manufacturing sector strengthened in October due to increases in the output balance, total order balance and export orders balance. The PMI for the construction sector fell slightly, but remains well above the long-term average. And these sectors contribution to GDP is minor. The huge services sector, now accounting for almost 80 percent of the economy, offered some evidence of a rebound in Q4, as the index increased. Overall, the data is good data, which confirms that the last quarter of this year most likely will show strong economic growth.
The Bank of England’s Monetary Policy Committee (MPC) voted by a majority of 8-1 to maintain the Bank Rate at 0.5 percent. The MPC sets monetary policy in order to meet the 2 percent inflation target, and in a way that helps to sustain growth and employment. The MPC also voted unanimously to maintain the stock of purchased assets financed by the issuance of central bank reserves at GBP 375 billion, and to reinvest the GBP 6.3 billion of cash flows associated with the redemption of the December 2015 gilt held in the Asset Purchase Facility. The MPC repeated its argument that the deviation from the inflation goal is mostly due to cheaper energy and a stronger GBP. The CPI forecast was revised downwards and the MPC now anticipates that CPI will return to target in Q4 2017. The central bank lowered its GDP forecast to 2.7 percent this year and to 2.5 percent in 2016. The rhetoric was quite dovish, but by no means as transparent as Fed chief Janet Yellen. Markets still have to guess when the central bank will make their first move – this has been the case since March 2009. In the meantime, the economy is performing well; moreover, households are in a better financial situation than before the crisis due to lower rates and stable wage growth.
The industrial sectors’ poor performance in combination with sluggish trade continues to reflect that the economy remains unbalanced. Even if the total trade balance narrowed in September, the trade deficit as a whole for Q3 is higher than previously estimated due to weak overseas demand. The industrial sec-tor survey showed higher confidence among purchasing managers in October, while the data reflected what happened in August. Looking ahead, the industrial sector should see a boost in Q4, albeit from low levels. Total sector performance in August is still almost 10 percentage points lower than in Q1 2008.
In terms of indicators, the UK labour market report for September is due on Wednesday. Despite the unchanged print, the labour market is still tightening, although at a slower pace than in 2013-14. As a result, wage growth as measured by average weekly earnings excluding bonuses (core AWE) has accelerated so far this year. This said, the estimate for the annual growth rate in core AWE (3M average) s likely to decline to 2.6% y/y in September, from 2.8% y/y in August, due to base effects explained by a very large jump in wages in September 2014. Also, for this reason, it is likely the annual growth rate will stay below July’s 2.9% peak in coming months. This should not be over interpreted, as the core AWE series is somewhat volatile. There is still increasing underlying wage pressure stemming from the tighter labour market.
Construction output for September is due on Friday. In the first estimate of Q3 GDP growth, the Office for National Statistics assumed that construction output rose 1.3% m/m in September. Despite strong construction PMIs in Q3, construction declined in Q3 and dragged GDP growth down. Construction data are prone to revisions and there could be some potential for an upward revision of the data. If so, this could imply that Q3 GDP growth was higher than currently estimated.
Japan
Large swings in oil prices and the yen have driven a wedge between industrial production (IP) trends and corporate earnings in recent quarters. Unsurprisingly then, confirmation last week that industrial activity had contracted for a second successive quarter, down 1.3% q/q through Jul-Sept compared to a 1.4% q/q fall in Apr-Jun, proved little cause for concern. Instead, the 1% m/m increase in the September IP, which came in noticeably above the market consensus of -0.6%, was seized on as justification for the Bank’s decision later in the week to hold policy steady.
This logic may be flawed. Certainly, there are signs of a bottoming out in the manufacturing sector, with the Japanese manufacturing PMI for October rising 1.5pts to 52.5, but the BOJ is likely to remain cautious over the risks emanating from China and the US. A better attempt to rationalise the Bank’s policy decision rested on the fact that, while the Bank’s primary measure of inflation remains negative, CPI ex-fresh food and energy was up 1.2% y/y. The argument here is that a temporary energy price shock is behind the Bank’s inability to meet its target and that domestic demand-generated inflation is emerging. There are problems with this interpretation too. Last year, the BOJ prioritised core CPI including energy prices (when energy was a big price positive), so a switch of focus to core CPI ex-fresh food and energy (when energy is a big negative) seems opportunist. Perhaps more importantly, the divergence between these two measures is likely to narrow as the impact of yen depreciation on core-core measures fade, while energy price base affects dampen the drag on core prices. The risks of a slowdown in core-core measures of inflation were already evident in the October Tokyo core-core CPI measure, which fell to 0.4% from 0.6% in September.
Of course, inconsistencies within the BOJ’s policy framework would be nothing new. Its timeframe for commitments have repeatedly slid – from 2% in two years, to mid-2016, and now end 2016/start 2017. It has altered its logic on inflation expectation changes too and reacted erratically to economic and price data; last October’s 0.2ppts downgrade in its price and growth outlook one year ahead triggered easing; this year’s 0.5 ppts downgrade in price and 0.1 ppts growth downgrade yielded nothing. All of this has made understanding the BOJ’s reaction function increasingly difficult. However, one must refrain from interpreting last Friday’s events as a turning point. The MPB maintained its medium-term scenario in which the headline CPI goes up to 2% y/y amid an improving GDP gap, continued tightening of the labor market conditions and steady and elevated expected inflation rates. In addition, the Bank has been too optimistic in the past and it will be difficult to achieve its forecasts – auguring for further easing. The biggest change is that April and October are no longer the only ‘live’ policy meetings – as the Bank is clearly comfortable with the inconsistency of a downgrade in its price outlook without adjusting policy. There is less clarity, though, on what the thresholds for further easing may be. Would a collapse in core CPI trigger easing? What role now for inflation expectations measures? Are wages the trigger? Unless the BOJ moves to restore some sense of order, volatility will remain high. Unfortunately, in the absence of a massive improvement in its communications strategy, the only conceivable way for the Bank to do this is through further easing.
China
It will be a busy week. Chinese FX reserves are released for October. Following the record-high decline in August of USD94bn, the FX reserve fell much less (by USD43bn) in September, pointing to a reduced capital outflow out of China. The expectation is for the outflow in October to show a similar picture, with an estimated decline in FX reserves of around USD30bn. If this is the case, this is likely to add to reduced fears of a Chinese hard landing.
On Sunday, the trade balance is due for release. The trade surplus is expected to hit a new high in October of USD62.2bn, up from USD60.3bn in September. Both export and import growth will stay weak around -3% y/y and -15% y/y, respectively. The export sector is suffering strongly from the emerging markets slowdown and a strong CNY.
CPI inflation is due on Tuesday. The forecast is for a decline to 1.5% y/y, from 1.6% y/y. This is well below the target of 3.5% and leaves plenty of room for monetary policy to ease if deemed necessary. However, the signs of recovery mean that the People’s Bank of China is nearing the end of easing, with only one more cut in the reserve requirement left this year.
Money growth and social financing data (broad credit) is also due on Tuesday. Credit growth from corporate bonds and bank loans has picked up recently, as the fiscal stimulus through investments is financed by more credit.
Finally, retail sales, industrial production and asset investment growth are due for release on Wednesday. The expectation is for a slight rise in the monthly momentum in industrial production as a signal by the rise in Caixin PMI manufacturing for October.
On another note, last week China concluded the Fifth Plenum and released its 3Q GDP data to heightened attention. Observers are now keenly watching what used to be arcane and oft-ignored events, such as the Plenum, for signs of where China is headed. Recent data have raised hopes that China’s economy has stabilised following a volatile summer. But any hopes that China would end its fixation on hitting GDP targets were quickly dismissed as China reported 6.9% GDP growth, perfectly in line with “around 7%” growth for this year. And if there were any doubts about China’s future GDP targets for the next five years, Premier Li Keqiang announced in a speech that China would need to achieve an average of 6.53% over the next five years. Looking past the unnecessary preciseness of 6.53%, especially when there is virtually no volatility in the official data, it’s important to know where this target comes from and why they will likely “achieve” it. In 2012, President Xi Jinping announced a series of economic targets including doubling of GDP and per capita household income by 2020. Doing the math, to reach this goal, China would need to achieve approximately 6.53% annual GDP growth and 6.7% per capita household income growth. Therefore, although authorities have yet to officially announce their targets, it’s highly likely 6.5% will be the goal for the next five years.
Regardless of the difficulty of maintaining such high growth over the next five years, it’s highly likely that published official data will hit the target (although there is room to remain sceptical about the validity of these statistics). After all, President Xi Jinping has personally set forth these targets. This government will not be the first, especially as it struggles to reinforce its credibility. However, the next five years will be some of the most difficult China will have to face as a modern economy. That’s not to say Chinese economic leadership hasn’t experienced crises. China endured the Asian financial crisis and a bout of bank restructuring. Policymakers also successfully navigated a transition from a planned economy to a capitalistic economy with “Chinese characteristics”. But China today is faced with significant domestic and external challenges with no simple solution. Eliminating overcapacity, increasing innovation, and boosting household wealth, all while maintaining social stability, is no easy task in a system that is becoming more restrictive, not less. In the view of many commentators, 6.5% growth over the next years is unrealistically high, and achieving that goal will at best further undermine credibility regarding China’s economic statistics. At worst, it will deepen imbalances that already exist. By most estimates, China has struggled to maintain growth above 5% this year, and given all the downward pressures facing China’s economy, 6.5% is problematically high.
Although GDP will always remain significant data point, it isn’t the most relevant statistic to capture China’s economic performance. With the economy undergoing large, structural changes, it’s more important to pay attention to the composition of growth and understand at a more granular level how the economy is changing. De-emphasising GDP, both within the government and among foreign commentators, would be a healthy step. Such hard and fast targets leave little room for daring structural reforms, even as they become increasingly necessary to achieve acceptably high growth.
Sources: Commerzbank, Standard Life Investment, Danske Bank. TD Economics, Handelsbanken