Daily Economic Briefing: January 25, 2010

Daily Economic Briefing: January 25, 2010

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Page 1: Global data summary

• The 12 central bank meetings this week will likely underscore that a one-size fits all global monetary stance is becoming increasingly inappropriate. As discussed on page 2 of last Monday’s DEB and in detail in a recent Global Issues report (Dec 17, 2009), the fading of the global shocks that pummeled economic and financial markets last year is leaving behind a much more fragmented landscape. Importantly, cross-country variation in economic slack and inflation will play a central role in relative policy outcomes. These two variables (output gaps and current core inflation) have provided a simple but powerful metric for gauging policy actions.

• Little is expected from the FOMC (Wed). The low-for-long language will be maintained, as will its justification: low resource utilization, subdued inflation, and stable inflation expectations. Separately, with his term ending this week, Bernanke will likely be reconfirmed by the Senate to chair the Fed, though the vote could be the closest in history.

• The BoJ could expand the amount or maturity of its capital injections (Tue) in response to increasing deflationary concerns, which have been amplified of late by the recent fall in USD/JPY and its impact on business and consumer sentiment. Close attention will be given to the business surveys this week. Today’s Reuter’s Tankan continued to show a large gap between the export oriented manufacturing and service oriented industries. Tomorrow’s Shoko Chukin small business survey, a key GDP indicator, will likely also remain lackluster. The December trade (Wed) and IP (Fri) data will confirm these divergences, showing Japan’s recovery is largely driven by external demand.

• Facing one of the largest output gaps among the countries we track, the NBH of Hungary cut its policy rate by 25bp today and remained one of the only 3 countries still in easing-mode (along with Russia and Romania). By contrast, the Bank of Israel left its policy rate unchanged today but has already hiked rates 75bp since last September in response to a relatively short and shallow recession. The COPOM in Brazil (Wed) is expected to stay on hold but shift its tone to signal a 50bp March hike, while the Reserve Bank of India (Fri) will keep its policy rate on hold but likely raise banks cash reserve ratio by 50bp.

• Upside surprises in EM Asia continue. In Taiwan, IP in December was stronger-than-expected. We now project GDP rose 8% (q/q, saar; revised from 6%) in 4Q09 and will rise 6.3%oya this year (revised from 5.8%). We’ve highlighted upside risk to EM Asia for several weeks. Given recent changes to our China and Taiwan projections, additional upward revisions in EM Asia seem likely.

• US GDP in 4Q09 (Fri) is projected to have leaped at an annualized pace of 5.7%q/q, a full percentage point above consensus. The strength largely reflects a much faster moderation in the pace of inventory de-stocking but also will show a 2.3% gain in personal consumption expenditures, a decent showing given the large drag from the cash-for-clunkers roll-off.

Page 2: Big time recessions, big time damage

One of our core views is that the historically elevated level of economic slack—informed partly by our estimates of individual country output gaps—will push underlying consumer price inflation down to below central bank targets throughout much of the developed markets (the US, Euro area, and Japan, in particular) and parts of the EM (outside EM Asia and Brazil). A valid counter-argument is that the magnitude and duration of the recession caused permanent damage to the productive capacity of the global economy and that the resulting lower level of potential output will close the output gap much sooner than we appreciate.

This debate is far from just academic. Recent communications from both the ECB and BoE give the sense that policymakers are quite open to the idea that the recession dealt the Western European economies a permanent blow and that the level of economic slack may be far less than if potential growth continued at its pre-recession pace. By sharp contrast, the Fed appears far less willing to accept the possibility of an outright fall in the level of potential output and continues to emphasize the elevated level of slack. It is important to keep these differences in mind when assessing the relative paths to policy normalization. With the ECB appearing the most resigned to a reduced hit to potential, it would not be surprising to see them start the policy normalization process earlier than the Fed.

Given that deep economic downturns are relatively rare, it is difficult to assess the validity of the argument. However, an examination of global GDP back to 1900 suggests that big-time recessions do lead to big-time damage. The deep global downturns after World War I, the Great Depression, and World War II each left a lasting imprint on the world economy. In the aftermath of these damaging events, economic activity did not bounce back to the levels that would have been implied by the pre-recession trends.

If the 2008-09 global recession is similar, we should expect some trimming in the level of potential output relative to the pre-recession trend. Otherwise, output gaps would be assumed to be much bigger than they are in reality. Perhaps the single best example of this is the auto industry. Notwithstanding the recent surge in EM auto demand (China in particular), few expect global auto sales to bounce back to the level that would be implied by their pre-recession trend. Because it is unlikely that the productive capital (both physical and human) used in the auto industry will be redeployed into equally productive uses, the potential level of output has been permanently lowered from what it would have otherwise been (note that this is different than arguing the previous peak will not be achieved; global auto sales have already reached the past cycle peak). A similar phenomenon occurred after the Cold War ended and the US defense industry was scaled back. Research shows that the redeployed defense-related capital did not have the same level of marginal productivity.

The implications are important for assessing the disinflationary pressure building up in some of these economies. The J.P.Morgan forecast already incorporates a slowing in potential output growth, even if in no cases have we projected an outright fall in the level of potential output (i.e. negative potential growth). Moreover, our inflation forecast also does not completely reflect the full extent of the estimated output gap, partly reflecting our uncertainty surrounding a number of issues, including the output gap. Still, a failure to adequately incorporate any structural damage that has occurred could put upside risk to our inflation call. And while it would not necessarily alter our growth outlook, it would also trim some of the upside risk from a stronger than expected bounce back in economic activity as output gaps are closed, a risk we’ve noted in these pages in recent weeks.

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ENDS

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