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Analysis

North America Focus: U.S.: Warming Up the Helicopter; Canada: Inflation Moderates Going Forward

By Christian Menegatti, Prajakta Bhide, Tetiana Sears and Rachel Ziemba

EXECUTIVE SUMMARY

We kick off our look at North America with the U.S., where incoming data are showing that growth in Q2 2010 was closer to 1.5%, compared with the advance estimate of 2.4%. With Q2 growth more anemic than even we expected, risks to our forecast for 1.5% growth in H2 2010 are heavily tilted to the downside. We will continue to monitor incoming data in Q3 2010 for additional signs of weakness. Looking at recent trends in inflation and inflation expectations, the gauges clearly display ongoing downward pressure; however, we consider the grim possibility that policymakers remain passive so long as inflation gauges do not show outright deflation. On a positive note, the latest announcement in the August Federal Open Market Committee (FOMC) meeting alleviates some concern of policy inertia. Moving north to Canada, we expect the July inflation data to show a continued downward trend. Recent changes in the tax regime will have a limited impact on consumer prices; meanwhile, the appreciation of the Canadian dollar will exert further disinflationary pressure in the Canadian economy. Moreover, inflation expectations remain well within the central bank’s target range. Risks to our own forecast for inflation in H2 2010 and 2011 are tilted to the downside. The central bank is unlikely to hike the policy rate at its September meeting.

United States

By Christian Menegatti and Prajakta Bhide

Week in review

Among U.S. data last week, notable was the trade balance for July, which surprised on the downside and was significantly lower than the estimate used by the BEA in computing the advance Q2 2010 U.S. GDP estimate. Moreover, recent data on business inventories show that the inventory build in Q2 was also less robust than earlier estimated. Together with a downward revision to investment in structures already takes us to sub 1.5% growth in Q2 2010. We have long maintained our theme for a year of two halves in the United States, with growth slowing to 1.5% in H2 2010. With Q2 already showing greater than expected weakness, and early indications on July and August economic data providing no reason to cheer, our 1.5% forecast for H2 2010 begins to look more like a ceiling for growth, which could come in considerably lower.  Indeed, retail sales posted a gain in July after two consecutive declines; however, core retail sales showed the third decline in the last four months. After posting a sub-par 1.7% gain in Q2 2010, consumer spending, which drives 70% of the U.S. economy, already seems off to a rocky start in Q3 2010.

This week, we will continue to monitor the leveling off in the manufacturing sector, with the release of industrial production for July. The increase in manufacturing work hours in the July employment report suggests a slight stabilization in manufacturing output after a decline in June, but we will pay close attention to the first of the August regional manufacturing surveys—the Empire State Manufacturing Index—particularly, the forward looking new orders component and the gauge for employment, which had shown contraction in July, and the Philadelphia Fed business survey. Other key data for the week are housing starts, where we see single family starts show continued sluggishness, given the 3.4% m/m decline in permits in June.

An additional signal of economic performance will come from the Conference Board Leading index for July, which has fallen for two of the last three months. We are closely monitoring the data as Q3 2010 evolves; while risks to our own “bearish” forecast of 1.5% GDP growth are heavily tilted to the downside, consensus is still pointing to a 2.5% growth rate in H2 2010. This should not come as a surprise: in early 2010, while we were arguing for a significant growth slowdown in H2 2010, consensus was still arguing for a V-shaped rebound. By mid-2010, consensus had converged to RGE’s views with a lag; we expect to see the same happening as we get further into H2 2010.

The July CPI data release by the U.S. Bureau of Labor Statistics showed a 0.3% m/m gain, driven entirely by the energy component. Meanwhile, removing the effects of energy and food prices, underlying core prices rose under 0.1%, and as of July, on a y/y basis, core prices have been tracking a sub-1% gain for four consecutive months. Compare that with the average y/y gain on 2% over the past decade.

The index for rent of shelter, comprising 40% of the core CPI, was flat in April and May 2010 and showed two consecutive gains in June and July. However, the gains were extremely weak, at 0.1% m/m. The index for shelter has been a significant source of downward pressure in core CPI, and some analysts point to the stabilization in mid-2010 as the beginning of firming in consumer prices. During 1997-2007, the shelter index in the CPI basket posted an average monthly gain of 0.3%. The index has been, on average, flat since 2008. Even if the shelter component shows stabilization, the high level of housing inventories suggests that gains will at best remain anemic, and well under the gains witnessed during the decade prior to the recession.

On the Rising Risk of Deflation: Are We There Yet?

Much has been said about the relative stability of inflation expectations in the U.S. economy. The Fed has certainly referenced the stability of inflation expectations on a number of occasions, to alleviate concerns regarding the downside risks to inflation. While the anchoring of inflation expectations has certainly been relevant, the idea that inflation expectations will not trend lower or even that they are not already doing so may not be well grounded. This is clearly evident from the downward trend in spreads between Treasury Inflation Protected Securities (TIPS) and Treasurys. There are arguments against using breakevens to gauge inflation expectations, but the signals arising from the bond market are hard to dismiss entirely.

Figure 1: TIPs Implied Inflation Expectations

Source: Federal Reserve Bank of St. Louis FRED Database, RGE computation

Moreover, estimates of inflation expectations from the Cleveland Fed seek to circumvent the shortcomings of gauging inflation purely from breakevens or survey based estimates. The Cleveland Fed’s estimates of inflation expectations have certainly trended lower in 2010.

Figure 2: Cleveland Fed Inflation Expectations

Source: Federal Reserve Bank of Cleveland

If expectations are slow to decline, it may be that the U.S. economy will not spiral into a period of outright deflation with a succession of negative prints on inflation gauges. Even so, the U.S. economy would be far from out of the woods when it comes to the risk of Japan-style stagnation. Indeed, as Professor Paul Krugman pointed out succinctly, the U.S. economy entered the recession at an already historically low inflation rate, and given nominal downward rigidity instead of outright deflation, we may see extremely anemic inflation rates for an extended period, sharply below the Fed’s target range.

However, while inflation is low and trending lower (though positive), the real interest rate continues to climb. And the risk is that mildly positive inflation leaves room for perma-hawks to press for inaction as the Fed’s policy response. This elevates the risk of an extended period of stagnation stemming from policy inertia and possibly even a period of flat GDP growth.

As said in the past, a double-dip is not our central scenario, but the risks are rising. The downside risks to our 1.5% growth forecast for H2 2010 not only will continue to be supportive of downward pressure on inflation and inflation expectation, but will get the U.S. economy very close to stall speed. Last week we wrote about how labor market slack continues to widen as job creation does not get even close to absorbing increments in the work force (let alone the open slack) and how this trajectory will become unsustainable if it were to persist. Growth of 1% or below for H2 2010 is consistent with prolonged malaise in labor markets and could be considered stall speed, a scenario that would bring the chances of a double-dip much higher than the 35% that we are penciling in right now. As we argued quite some time ago (Exit Strategy: Damned If You Do and Damned If You Don’t), a not-yet self sustained recovery, coupled with a policy mistake, can result in another period of contraction and could prolong the period of slow growth ahead. In the event of the “stall-short contraction-slow growth” scenario, one could argue that this recovery might look somewhat like an inverted square root with the output gap in widening mode for quite some time. (Note that these are not our forecasts, but just one possible scenario to contemplate.)

Figure 3: Visualizing a Growth Stagnation Scenario

Source: Bureau of Economic Analysis, RGE Scenario Projection

FOMC: Warming Up the Helicopter

The president of the Federal Reserve Bank of St. Louis, James Bullard, recently highlighted that in a period of falling inflation, as the nominal policy rate approaches the zero bound, the monetary policy regime (a Taylor rule in which nominal rates respond to deviation of inflation from the [implicit] target) switches from active (nominal rates move more than one-to-one with inflation)  to passive (nominal rates move less than one-to-one with inflation) and the economy runs the risk of falling into an “unintended steady state” of negative inflation and zero nominal interest rates. Bullard noted that, at the zero bound, a pledge to keep the policy rate at zero for an extended period may indeed be consistent with an increase in inflation expectations, but it may also be consistent with a decline in inflation expectations. With inflation well below target, and policy becoming passive, the economy runs the risk of getting mired in an extended period of low inflation and low nominal rates (a la Japan). Bullard noted the rising risk of such an outcome for the U.S., calling for a policy regime shift to quantitative easing through the purchase of Treasury securities, taking the recent policies of the UK as a model—rather than the recent U.S. mortgage-backed security program.

This brings us to the statement of the August 2010 FOMC meeting. The string of weak economic data, including a dismal jobs report prior to the FOMC meeting, implied significant pressure on the Fed to show some cognizance of the stalling economic recovery. As a result, the Fed maintained its pledge for keeping the fed funds target low for an extended period, but also announced that the principal payments on its Mortgage Backed Securities (MBS) and Agency debt would be reinvested in Treasurys, implying that instead of the passive tightening from the runoff of its portfolio, the Fed’s security holdings will now be capped at current levels. 

As we noted in the Q3 2010 outlook for the U.S. economy, the Fed has been laying the verbal groundwork for further monetary stimulus, which in our opinion is a much-warranted outcome. For now, we believe that the latest announcement must be regarded as a signal to the gradual, forthcoming change in the policy stance. In itself, the implications for the broader economy are likely limited. (For details on the expected impact of the intended purchases on Treasury yields, see RGE Strategy Flash: Deus Ex Machina.) Moreover, the decision to reinvest the repayments in Treasurys reflects the preference expressed by many FOMC members for an expeditious return to the Fed’s traditional Treasurys-only portfolio.

This brings us to the question of what alternatives does the Fed have to provide additional policy stimulus and to which degree they can be effective, which we will explore in a forthcoming analysis.

Canada

Canadian Inflation: Temperate Growth Going Forward

By Tetiana Sears and Rachel Ziemba

Canada’s CPI data for July is due on Friday this week and should show that inflation trends remain subdued. The most recent data (June) suggested that core inflation continued to moderate to 1.7% y/y. Going forward, we expect a number of domestic factors to keep the core inflation trends muted in H2 and into 2011. Even the likely bump in headline inflation of 0.4% from the new tax regime (HST) implemented in Ontario and British Columbia in Q3, will little pass through to core inflation, which we expect will remain anchored within the central bank’s target range of 2%. As the measure of core inflation excludes indirect taxes, the tax harmonization might only exert slight downward pressure as a result of businesses passing savings to consumers. However, as this effect is likely to be tame, overall macro economic trends will have a more significant impact.

The strong Canadian dollar, which has appreciated around 10% annualized since July 2009, should add to disinflationary pressures, even though Canada tends to have sticky prices, which are slow to adjust downwards as the currency appreciates. The pass-through effect in the value of the CAD into consumer goods tends to lag at least six months and in some cases more, which suggests that the most effect on inflation from the recent appreciation is still to come. In fact, the June decline in prices at clothing and footwear stores could have been exacerbated by the currency moves.

The extensive excess capacity, accumulated during the recession of 2008-09, will also weigh on core inflation, though Canada’s output gap is much narrower than that of the U.S. and some of the slack was absorbed at a faster pace. Despite the fact that robust economic growth in the second half of 2009 and early 2010 helped narrow the output gap, it will close more sluggishly as economic outlook slows in H2 2010. In July, the bank of Canada revised its estimate, suggesting that the economy will reach full capacity only by the end of 2011, two quarters later than was previously estimated. The central bank also estimated that the output gap stands at around 1.5% in Q2, with the bank expecting Q2 real GDP growth to be at 3%.  However, given the weakness of the global economy, it could take even longer to close the gap, especially if domestic growth slows more than anticipated.

Inflation expectations are another significant factor in determining the rate of inflation. The results from a recent business survey indicated that the majority of polled firms expected inflation to remain well within the central bank’s target range of 1%-3%.

As all these factors set to converge in H2 and in 2011, we will see the risks to the current inflation outlook being tilted to the downside and could actually contribute to a slightly weaker inflationary outlook for 2010 as a whole that we anticipated in our outlook. Canadian policy makers acknowledged this trend in July’s monetary policy report, also citing the “decelerating pace in labor compensation” and expected moderation in public sector spending to contribute to gradual reduction in inflationary pressures.

Given these dynamics, it appears that the central bank should have less impetus to continue raising interest rates when it meets in early September. The softer inflation outlook combined with considerable slowing of economic activity in the U.S. and globally, will most certainly weigh on the trajectory of the tightening cycle in Canada. Given the Fed’s recent downgrade of the economic growth and its first step in the direction of further quantitative easing, the Bank of Canada is unlikely to hike at its September 8 meeting, which is in line with their commitment to “weigh carefully any further reduction of monetary stimulus against domestic and global economic developments.”

Figure 4: Inflation Well Within Target Range

Source: Statistics Canada

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