Daily Economic Briefing: April 27, 2010

Daily Economic Briefing: April 27, 2010

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• Even as some hangovers from the severe recession are gaining in intensity (Euro sovereign stress, US financial reform), the global indicator flow mostly is surprising us on the upside. The leading edge concerns the early April business surveys, which hint that (i) our global PMI advanced to yet another expansion-high this month; and (ii) the pace of global growth has strengthened in the current quarter. Notably, the surprises are coming from across the globe and include both manufacturing and services, and small as well as large businesses.

• In today’s reports, we were pleasantly surprised to see that Japan’s Shoko Chukin small business survey rose an additional point to 46.8, led by a gain in the service sector. This month’s gain followed a large 3.5 pt increase in March and hints at a significant acceleration in the economy that may be carrying over to the current quarter (note that the S-C survey always has exhibited a significant negative bias, which helps explain the relatively low level of the survey in an expanding economy). Our team is reviewing its 2010 growth forecast and almost certainly will mark it higher by the end of this week.

• The available regional Fed surveys of US manufacturing activity in April also have posted gains. The average of the four ISM-weighted composites increased 3.5 points in April vs March, hinting at a gain in the national ISM index, which is out next Monday.

• The evidence for Japan and the US is reinforced by last week’s European results for April. The Euro area composite PMI (which covers both manufacturing and business services) rose 1.4 pts to 57.3 this month. The PMI did not reach this level in the previous expansion until early 2006.

• It is well recognized that even as DM growth heats up, it remains well below the pace of growth in the Emerging economies. The hottest region remains EM Asia, where we recently raised our 2010 forecasts for almost every country in the group. That said, as 1Q GDP forecasts roll in, they are surprising on the upside. Today Korea reported 1Q GDP growth of 7.5% annualized (7.8%oya), vs JPM fcst of 5.6% and consensus of 6.0%. In addition to the breadth of Korea’s demand growth, one notable feature of the report is that Korea was still liquidating inventory last quarter. Korea’s impressive 1Q GDP growth follows annualized gains of 13.1% in China and 32.1% in Singapore.

Assessing the damage from an unexpected rise in oil prices

The global economic recovery appears to be gaining momentum. This shows through in the official activity data and, as discussed on page 1, in the more timely business surveys. Behind this momentum is a positive interaction between policy, confidence, asset prices, consumption and business spending. Working against these classic recovery dynamics are remaining structural headwinds (e.g., personal saving, real estate, government finances). Striking the right balance between these opposing forces requires a constant monitoring of data and market/political developments.

One potential risk to the economy that has not been in the headlines lately is commodity prices. The 2000s expansion demonstrated that quick, sharp increases in energy and food prices, through their effect on inflation and consumer spending, can deliver a significant setback to economic growth. Moreover, we saw during the last expansion that the supply/demand dynamics in the commodity markets can be vastly different from what is implied by our broad measures of resource slack. Commodity prices took off early in the 2000s expansion, even as excess slack was pushing down on core inflation. The wedge between headline and core inflation persisted throughout the economic expansion.

Commodity prices are displaying a somewhat similar pattern so far in the current expansion, posting impressive year-on-year gains even as core inflation makes new lows. The gains are focused in industrial metals, which have the least influence on consumer prices, and to a lesser extent in oil prices. Agricultural commodity prices have been relatively quiescent, notwithstanding the rapid pace of food inflation in some EM economies.

Much of the year-ago increase in oil prices occurred in 1H09, when prices quickly shot above $70/bbl. The rise since that time has been fairly modest, although prices have shown signs of an escalation in the past two months, having made a convincing break above $80/bbl in April. Our global energy strategists look for a gradual rise in oil prices from current levels to $90/bbl at year’s end. However, their recent communications have said this forecast may be raised.

While the global economy is better positioned to absorb higher oil prices than it was a year ago, a sharp jolt to prices would pose an important drag on household incomes and consumption that is not built into the forecast. By this, we mean an exogenous shock to prices unrelated to a strengthening recovery. We have developed rules of thumb to assess the economic impact of higher oil prices (see “Assessing the global drag from higher oil prices,” Global Data Watch, June 19, 2009). In particular, our analysis suggests that a 10% rise in the price of oil increases the price of the consumer basket roughly 0.7%. Thus, if oil prices were to rise from $80/bbl to $100 in a quarter (a 25% increase), the annualized inflation rate would climb by roughly 1.75% points. In turn, a 1% increase in consumer prices damps consumer spending roughly 0.5%, all else equal. Thus, a jump in the price of oil from $80/bbl to $100/bbl in one quarter would reduce annualized consumer spending growth by about 0.9% points, shaving GDP growth by about 0.6 points.

While considerable, this probably understates the damage that would be done to economic growth. For one thing, a shock to energy prices probably would hit confidence and financial asset prices, amplifying the hit to spending that comes from the squeeze on household purchasing power. It also might shake business sentiment, damping the recovery in business spending, including on employment. To be sure, a jump in oil prices that merely reflects a strengthening recovery, while a regulator on growth, is not an impediment to growth.

Faced with extremely high unemployment and low and falling core inflation rate, the G-3 central banks likely would view a spike in oil prices as a tax on demand, rather than worrying about the implications for pass-through. As such, it would reinforce their intention to leave policy on hold for the foreseeable future. The same cannot be said for some of the EM economies, where output gaps already have closed and core inflation is beginning to move up. In these cases, a jump in oil prices might hasten the shift to higher policy interest rates and Fx rates.

ENDS

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