Daily Economic Briefing - July 28, 2010
Outside the US, the early readings on macroeconomic conditions at midyear have shown notable resilience. The data flow from the Euro area continues to contradict the view that the sovereign credit crisis has done material damage to the regional economy as a whole, notwithstanding the real damage underway in the peripheral economies. Last week's surprising move up in the July PMI was followed by a surprising move up in consumer confidence. Today's Senior Loan Office survey sends a similar message. Although banks continued to tighten lending standards into the current quarter, the breadth of tightening continued to moderate and is nearing the point at which conditions begin to ease.
The resilience of business sentiment outside the US was underscored today by a surprising move up in Japan's small business sentiment index. The Shoko Chukin, which is the single best indicator for the underlying pace of GDP, continued to trend up, reaching 48.1 in July. Although the June demand and production indicators released later this week are expected to soften and lead to a slight marking-down of our 2H10 outlook, today's reading could temper that revision. If sustained, the current level of the Shoko Chukin is typically consistent with real GDP growth of about 2.5%, in line with our current outlook. It is also worth noting that the manufacturing component of the diffusion index moved up further to 50 for the first time since April 2007.
In the US, yesterday's slide in consumer confidence stands in contrast to that of the EMU and Japan. Today's durable goods report was also a touch softer than expected, with core capital goods shipments (an input for capital equipment spending) edging up just 0.2% in June. However, the underlying trend, at 15.8% (3m/3m,saar) remains strong, and although core orders in June were a bit weaker than expected, May was revised up by a greater degree. On net, US capital equipment expenditures appear to continue expanding at a robust pace of 10-12%(ar) into 2H10. The Fed's Beige book also pointed towards a moderation in growth.
Today's 2Q inflation report in Australia surprised on the downside, both in terms of the headline as well as the core rate. While not the only metric by which to gauge monetary policy, the case for an August 3 RBA rate hike has substantially diminished and we have pushed back the next rate hike until later this year, with the policy rate reaching 4.75% by year end. Further hikes are still expected in 2011, however, as the soaring terms of trade, a tight labor market, and building wage pressure, will halt the downward descent of core inflation and result in a move back up above target in 2011.
Although economic activity decelerated some in Brazil last quarter, credit conditions continued to move up. According to the central bank's June credit report, total outstanding credit moved up to a new historical high of 45.7% of GDP. Despite the fact that the macroeconomy appears to be downshifting slightly at midyear, and despite the fact that delinquency rates continue to drift lower, we maintain our call for the COPOM to hike rates 175bp between now and the middle of next year.
In general, inflation is driven by three factors: supply shocks (e.g. commodity prices), economic slack, and inflation expectations. Thus, adjusting inflation for movements in commodity prices and the level of resource utilization leaves only the effects of expectations. Using a model to control for these factors allows us to back out a modelbased estimate of inflation expectations for a number of developed market (DM) economies. Expectations have fallen since the early 70s, when periods of accelerating inflation resulted from a loss of central bank credibility. Expectations trended down through the 1980s and continued to do so as central bank credibility returned. By the late 1990s, inflation expectations settled almost exactly at the 2% inflation target and remained well anchored over the subsequent decade. However, the model based estimates show a recent statistically significant decline in expectations to 1% over the course of the recession, consistent with the fall in inflation in the wake of the downturn as well as concerns that it will take a long time for economic slack to be reduced.
The DM experience is roughly paralleled by each of the G- 3. In the US, loose monetary policy caused expectations to rise in the 1970s, before embarking on a downward trend following Paul Volcker's assault on inflation. Over the past 15 years, expectations were a touch over 2%. The Euro area entered the 70s with higher expectations than the US and DM as a whole, but experienced a sharp fall in expectations through the 80s, when their descent slowed before settling at about 2% by the mid 90s. Japan, which began the 70s with the highest expectations of any of the G-3 also saw the steepest fall, of about 9%-points, over the next few years. As the economy slid into deflation, a deflationary psychology has taken root, with expectations slipping below zero in the lead up to the recent recession.
Inflation expectations in most of the developed economies have drifted down over since the start of 2009. In both the US and the EMU, inflation expectations have taken a step down by roughly 1%-point. The model based estimate of expectations has also stepped down in Australia and Canada. Oddly, Japan has seen a move up in the modelbased estimate of expectations. A similar move has been seen in the UK. However, in both cases, the moves have not been statistically significant.
Markets appear to be pricing in declining inflation expectations. The implied 5y/5y forward inflation rate, derived from yields on inflation-protected securities, have been trending down recently, though the US and UK levels remain within their expected ranges. However, the rate in the Euro area lies a bit lower, both in level and relative terms and is likely raising some concerns in the halls of the ECB.