Daily Economic Briefing: April 20, 2010

Daily Economic Briefing: April 20, 2010

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• In yesterday’s DEB, we noted that while just about every country we track (and reports unemployment and core inflation) has seen a rise in their unemployment rate and a fall in their core inflation rate, these responses have varied considerably. Consequently, even as a synchronized growth recovery gains momentum, divergent levels of economic activity and inflation outcomes are pressuring central banks to act at varying speeds. At the vanguard are the EM Asian and commodity producing economies.

• In India, the RBI has been gradually removing accommodation. Today, the RBI hiked its key policy rate an additional 25bp and lifted the reserve requirement ratio by a similar magnitude. The bank expressed concerns that inflation is being accentuated by rising domestic demand pressures. Indeed, economic activity is ramping up quickly, resulting in accelerating consumer and asset prices on top of surging food prices.

• Brazil has tracked EM Asia at the vanguard of the recovery and yet their highly accommodative monetary and fiscal polices have not been adjusted as of yet (We expect the first rate hike to come at next week’s COPOM meeting). With economic activity firing on all cylinders, it is little surprise that inflation continues to pick up. Today, it was reported that the April IPCA-15 (a preview for IPCA target rate, out May 7) rose 0.48%m/m. Although this was a touch softer than the March reading, the rate remains above the COPOM target and core goods and cyclical service prices are reported to have accelerated.

• Among the central banks of early-moving commodity producing countries, only the RBA has consistently removed the emergency stimulus measures put in place during the downturn, having hiked rates in 5 of its last 6 meetings. No doubt, Australia’s proximity to the boomy gains in EM Asia have helped. At the same time, Norway’s proximity to the slow-to-recover Western Europe explains the Norges bank’s false-start on its exit strategy which began last September but ended in December and is not expected to begin again until May. By contrast, the fast improving US economy is giving the BoC a green light. Although the BoC remained on hold today as expected, it noted in a fashion similar to the RBA’s rhetoric, that “...the need for such extraordinary policy is now passing, and it is appropriate to begin to lessen the degree of monetary stimulus." We now see the BoC’s rate-hiking cycle beginning with the June meeting rather than in July.

• In contrast to the high-beta recovery economies, economic activity remains near its recession lows in the UK. However, inflation continues to nag the MPC. To wit, the CPI jumped a stronger-than-expected 3.4%oya in March. The rise was broad-based with core inflation edging up to 3%oya. We maintain that a slow start of the recovery combined with elevated economic slack will push core inflation back down to 1.2%oya by year end. For the time being, the MPC shares this view, preferring to characterize the recent inflation moves as one-off events related to the VAT-hike. Still, headline inflation has further to rise. This will trigger an open letter from BoE Governor King to the Chancellor this month and remind some that inflation has overshot the MPC’s target by 0.6%-point on average since 2006.

• TThe recovery in Sweden also is slow-going, leading the Riksbank today to hold its policy rate an extremely accommodative 0.25%. Although the statement was a touch hawkish in its positive tones regarding recent improvements in the labor market, we maintain that the bank will likely be disappointed in the 1Q10 growth outcome and surprised at the pace of decline in core inflation rates in the coming months. As such, we do not see the bank hiking rates until early next year. That said, with the bank holding onto its intention to hike sometime in late summer or early autumn, our view is being challenged.

Page 2 of 2: This time has to be different

As the household and corporate sectors delevered aggressively in 2008 and 2009, the only balance sheet left to support aggregate demand was that of the public sector. And lever up is precisely what the public sector did, as massive global fiscal stimulus played an important role in preventing the next Great Depression. But this has not come without a cost, particularly for the developed markets (DM). A rare plunge in DM government revenues along with a rise in outlays led to a post-WWII-high fiscal deficit of over 8% of GDP in 2009, with little improvement expected in 2010.

And while we project robust above-trend growth in the DM in 2010 and 2011, the pace will be far less than boomy given the depth of the downturn. Consequently, deficits in the DM will remain a permanent fixture on the economic landscape well into this decade. Gross debt of the DM public sector, which was around 70% of GDP just prior to the global financial crisis, will rise to over 100% by the end of next year and continue expanding in the coming years, potentially reaching about 115% of GDP by 2015 absent a material shift in public sector finances.

The rise in DM fiscal debt relative to GDP in the coming years is not entirely inevitable but rests on two factors. First, DM interest payments on existing debt (relative to GDP) will reverse their decade-long decline as the level of debt continues to ratchet up and as the average interest rate paid on government debt, which had fallen for over a decade, begins to rise. The second factor will be the likely slow pace of closing the primary deficit (i.e. the deficit excluding interest payments).

While the expected rise in interest payments relative to GDP will be difficult to avoid with the almost guaranteed rise in rates, the primary deficit is a policy choice. The projection made here assumes that the cyclical portion of the primary deficit, which tracks the business cycle with impressive stability, continues to track the cycle over the coming years. That is, the cyclical primary deficit is estimated to only slowly fall from 1.5% of GDP in 2010 to zero by 2013.

This leaves the structural primary deficit as the key policy choice variable. Here, history has not been promising. Indeed, the DM structural primary deficit has become far more cyclical over the past 15 years. Consequently, the fiscal costs of recessions have risen. The estimates shown here through 2015 are just that: estimates based on recent historical experience. However, in the coming years, policymakers will need to balance the near-term fragility of the recovery against the medium-term costs of fiscal imprudence as sovereign credit concerns begin to dominate the economic dialogue. Ultimately, debt sustainability in the coming years will require a material shift toward fiscal consolidation. In short, this time has to be different.

ENDS

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