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Despite Challenges, Charlotte Finds A Way To Grow

Tue, Jun 24 2008, 14:27 GMT
by Mark Vitner

Wells Fargo Investments, LLC

Charlotte is one of only a handful of medium-sized metropolitan areas to break into the ranks of first tier markets during the past decade. Solid population growth, a well diversified economy, generally good governance and an enviable quality of life have moved Charlotte forward. The metro area is often ranked as one of the best places to do business, raise a family, find a job, or start a new company. Most recently, Charlotte attracted a great deal of attention for being the lone metro area in the S&P/Case-Shiller 20-City Home Price Index to post a year-to-year increase.

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Published on  Tue, Jun 24 2008, 14:27 GMT

Breaking Water: Monitoring the Recession's Progress III

Wed, Apr 23 2008, 13:56 GMT
by John Silvia

Wells Fargo Investments, LLC

Both employment and personal income are showing the stress of the recession. Over the first quarter both series have fallen far below their trend values. This suggests continued weakness in the overall economy through the current quarter and below par growth in the second half of the year. Still too early to make the recovery call.

Employment and Personal Income: Recession-Like

• • The downdraft in the employment series, shown below, has been fairly dramatic over the last six months. The degree of weakness is reminiscent of prior recession periods.
  

• • Similarly, personal income growth has slowed dramatically suggesting weaker consumer spending. Employment and income weakness is likely for the rest of this year.
  

Sales and Production: Far Less a Slowdown

• • Real manufacturing and trade sales began to weaken in mid-2006 and served us well as a signal that underlying demand in the economy was declining. Yet the extent of that decline remains modest at this time. Recession may be here but the extent of the decline appears modest.

• • Meanwhile, industrial production is also just a bit below trend.

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Published on  Wed, Apr 23 2008, 13:56 GMT

ABA Economic Outlook Strategic Session

Tue, Oct 23 2007, 15:32 GMT
by John Silvia

Wells Fargo Investments, LLC

Five economic fundamentals provide the framework for any proper economic baseline for the year ahead. These short run, business cycle fundamentals are growth, inflation, interest rates, corporate profits and the dollar. In addition, strategic planning must also account for longer run behaviors. This discussion therefore takes a peak at key long run influences such as demographics, education and global growth.∗

Slower Growth but No Recession

Discerning between slower growth and recessions (negative growth) requires a more nuanced examination of economic trends. In Figure 1, next page, the slower pace of economic growth is evident in the year-over-year growth rate of real gross domestic product (GDP). There remains a significant difference, however, between current activity and the experience of 2000-2002. Over the last few months, the worst fears about the near-term economic outlook subsided considerably following the release of the September employment figures, manufacturing surveys and retail sales. Job gains were stronger than expected in September while the August decline in jobs was revised to a modest gain. The ISM manufacturing survey and retail sales numbers suggest continued growth. For the intermediate term, we will get our first look at third quarter real GDP on October 31. Our latest estimate has third quarter real GDP rising at around a 3.5 percent pace and there is a good chance that growth will come in above our estimate. Any recession talk is contradicted by two reliable indicators of growth. First, jobless claims, which come out every Thursday morning, remain in the positive growth range of 310,000 to 330,000 on a four week moving average basis. Second, the Institute for Supply Management (ISM) index remains in the positive growth range of 52 to 54 percent, where 50 is considered break even. The ISM indicator subcomponents of production, new orders and supplier deliveries remain above the 50 break even level.

Recent economic strength reflects the impact of robust consumer outlays during the quarter as well as strength in non-residential construction, government and trade sectors. Consumer spending is being helped by income and labor market fundamentals. Household net worth has benefited from gains in equity markets. Meanwhile, labor market improvements have slowed in terms of actual job gains, to a pace slightly below what is necessary to hold the unemployment rate steady. However, labor compensation has improved along with continued low inflation. Real household incomes have continued to improve enough to sustain a positive trend in real income. Looking ahead, spending for big-ticket items such as automobiles and household furniture is expected to slow in coming quarters, as adjustable rate mortgages reset upward. Slower job and income growth will also curb consumers’ willingness to spend this holiday season. The outlook is for slower growth but growth nonetheless.

Longer Term Influences on Growth and the Strategic Vision

Over the last forty years there has been a consistent shift in population growth from the Northeast and Midwest to the South and the West as evidenced in Figure 2. This pattern reflects the fundamentals of the cost of land, labor, and personal income taxes and, over the last two decades, the rising tide of retirees living in the South and West. This population shift drives the top line revenue growth for community banking.

These same trends should hold over the next 15 years according to the U.S. Census bureau (Figure 3, next page). The upper Midwest and the Northeast will continue to shed population, as baby boomer retirees and job seekers alike seek opportunities in the Sunbelt and the West.

Another demographic trend has been the rising returns to education. Mean family income data from the Federal Reserve’s Survey of Consumer Finance (Figure 4) shows that income growth for high school graduates and those that fail to graduate is far slower compared to those who even obtain some college education. This suggests that banks will increasingly benefit from rising income/educated households as a source of deposits and credit quality loans in the years ahead.

Gains in Capital Spending, Non-Residential Construction—Housing Correction Continues

Over the last year we have witnessed strength in business equipment spending for information processing and software equipment while other capital spending has slowed sharply. Strength for spending in the information economy appears to be a secular story. Global competition compels competitors to invest to compete effectively.

Meanwhile, non-residential construction has been solid for the last six quarters (Figure 5). Lending for takeovers and sales of commercial real estate properties will now be more prudent and based on much more conservative assumptions of future revenues. Prices of commercial properties may fall back a bit as well, but commercial construction should be restrained only modestly, as office vacancy rates remain relatively low across the country and rents are increasing. A repeat of the second quarter’s solid 26 percent annualized gain in structures spending is unlikely anytime soon, but a sharp downturn is just as improbable.

Residential housing spending continued to weaken during the year. Now that conditions in the credit markets appear to have stabilized somewhat, we have a better, but still uncertain, idea of the potential impact. Credit is being constrained for riskier borrowers and will likely remain tight. Some loosening in the sub-prime market will eventually occur, particularly for fixed-rate mortgages, where credit quality remains relatively good. Our view is that real residential investment will be less of a drag on growth in the year ahead (Figure 6).

Inflation: Within Fed’s Target Range but Limited Further Progress

While inflation data suggest that the core personal consumption deflator (Figure 7) remains in the top end of the Federal Reserve’s range, further progress does not appear to be in tow. Core producer prices are up 2.2 percent over the last year as of August 2007 compared to a mere 1.2 percent reading a year ago. Meanwhile, the ISM prices-paid index came in at 59.0 compared to a peak of 73 in April where 50 is the breakeven point between rising and falling prices paid. The prices paid index has been above 50 all this year. Finally, productivity growth has slowed and we witnessed a rise in unit labor costs of 5.1 percent in the second quarter. Unit labor costs have climbed since 2004, the bottom of the recent cycle.

While higher gasoline prices remain a risk, there is a growing probability that most of the damage is behind us. We are beginning to see some moderation in housing costs, which should also help to contain core inflation. The core PCE deflator should remain near the top-half of the Fed’s comfort zone.

Fed Takes a Wait and See Attitude

From mid-2004 to early 2006 the Fed has followed a policy of getting the funds rate back to “neutral’ and then keeping the funds rate steady for over a year (Figure 8). Longer-term, however, we suspect the Fed remains cautious on the inflation outlook and is unlikely to ease very much despite the current set of economic numbers. As for inflation over the last few quarters, we have seen a steady rise in unit labor costs along with steady gains in the core finished goods component of the producer price index. These developments suggest the Fed will take its time to ease. The minutes from the latest FOMC meeting contained one surprise in that the Fed decided not to provide a balance of risks assessment. We interpret this move as an attempt by the Fed to make it clear to the financial markets that they can react to a financial crisis without giving in on inflation. Carried a step further, the Fed’s comments seem to indicate to us that September’s half point rate cut and any additional cuts we might see are intended to provide a temporary respite for the economy and financial markets. Interest rates will climb once the economy and financial markets firm up.

We now have the Fed on hold, with a bias to ease, through all of next year. With real GDP growth expected to be around a two percent pace for the next two quarters, there is a risk that some sort of exogenous shock coming from the financial markets or overseas will trigger some additional moves by the Fed. Any such moves would come after the October 31 FOMC meeting, when the economy is likely to look pretty solid. Current Fed policy inaction appears primarily designed to prevent the problems in the sub-prime mortgage market from spilling over into other parts of the economy. The Fed will also likely remain alert to taking further steps to restore liquidity to credit markets, especially the asset-backed commercial paper market, possibly by reducing the discount rate further and broadening the rules on what can be pledged as collateral at the discount window. Rising LIBOR rates (Figure 9) suggest bank credit quality concerns still exist in the private sector and may point to similar anxiety at the Fed as well. This credit restraint will impact the availability and supply of credit in the coming year.

Up to this point inter-bank credit tightening has not filtered down to the commercial lending segment, as it appears credit quality in the private, non-mortgage, sector continues to be solid. Credit card delinquency rates have increased modestly but remain much lower than that experienced during the last recession. Meanwhile, auto loan delinquency rates remain low relative to their performance over the past decade. Finally, credit supply does not appear to be severely constrained. As illustrated in Figure 10, the percentage of banks tightening credit standards on commercial and industrial (C&I) loans remains far below the credit restraint level associated with the 2001 recession.

Corporate Profits; Slower Growth

While growth has slowed for corporate profits, it remains fairly solid for this stage of the business cycle. After a few years of recovery, the typical economic expansion goes through a period of slower top line revenue growth accompanied by rising input costs. From our discussion of growth above we note that aggregate economic growth is slowing in the economy. On the cost side, there has been a rising trend in unit labor costs as illustrated in Figure 11. Rising unit labor costs are the product of the combination of slowing productivity gains (also shown in Figure 11) and rising compensation to labor. This rising compensation reflects the increasing shortage of skilled labor that occurs as the economic expansion moves ahead.

A new twist during this economic expansion is the boost to profits of major multinationals with large international operations that occurs when the dollar depreciates relative to key foreign currencies. In this case, multinational companies headquartered in the U.S. earn higher valued dollar returns when those returns are earned in currencies such as the euro and Canadian dollar that are appreciating relative to the U.S. dollar. This complicates the picture for calculating the dollar’s effect on overall corporate profit growth.

Dollar: Losing Ground

When benchmarked by the Fed’s “Major Currency” index, which measures the dollar’s value against seven major foreign currencies, the dollar continues to lose ground (Figure 12). Looking forward, we project further dollar depreciation in the quarters ahead. Why? For starters, the current account deficit, although beginning to narrow a bit, should remain “large” for some time. Second, interest rate differentials between the United States and most major foreign countries are not very supportive for the greenback at present. U. S. interest rates are likely to remain stable or decline slightly. Euro rates are likely to remain stable for some time.

In addition, recent dislocations in credit markets, which should keep new issuance of structured fixed income products depressed for some time, will give foreign investors fewer U.S. securities to purchase, which will weigh on net capital inflows. The dollar decline last month after the Federal Reserve cut its target for the fed funds rate by 50 basis points. Not only did the larger-than-expected reduction in the Fed’s policy rate cause short-term U.S. interest rates to decline, which reduced the relative attractiveness of U.S. assets, but it also stoked expectations of further Fed easing.

Capital Inflows and the Depreciating Currency

One risk to the outlook that we should recognize is the delicate balance between foreign investor’s willingness to purchase U.S. assets (Figure 13) and the risk of currency loss on those assets. Since net capital inflows to the U.S. (demand for dollars) continue to fall short of the current account deficit (supply of dollars) this exerts downward pressure on the dollar. To the extent foreign investors anticipate continued future dollar depreciation, the risk to U.S. capital markets is that interest rates will rise to compensate foreign investors for the currency losses. This pattern of weaker dollar, higher rates and an aversion to U.S. assets remains a risk but we do not expect a dollar meltdown to take place, i.e., foreign investors dumping their holdings of U.S. assets on a large-scale basis.

Our capital markets remain the broadest, most liquid, and most transparent capital markets in the world, and we do not expect foreign investors to lose all faith in the ability of U.S. consumers, businesses, and government to honor their financial obligations on a widespread basis. In our view, the probability of a complete meltdown in the value of the greenback is rather low. Notwithstanding the possibility of a near-term dollar correction, the most likely scenario is for the greenback to continue to depreciate at a modest pace over the foreseeable future.

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Published on  Tue, Oct 23 2007, 15:32 GMT

California Is Rolling With The Punches

Mon, Oct 22 2007, 11:06 GMT
by Adam York, Mark Vitner

Wells Fargo Investments, LLC

California’s Economy Is Proving Remarkably Resilient

When you think of California’s economy today one of the first thoughts to come to mind is the collapsing housing market. California was one of the biggest participants in the housing boom and is now seeing the backside of that. Home sales are plummeting and prices are falling in many metro areas. The broader economy is assumed to be following the same route. Fortunately, it is not. Overall job growth is holding up relatively well and the Golden State’s Gross Domestic Product is still expanding. We estimate that California’s real GDP grew at a 2.8 percent annual rate during the third quarter and rose 3.7 percent over the past year.

Not only has overall growth held up relatively well to date but we expect the economy to continue to post solid gains over the next couple of years. This is not to say that the sharp reduction in new home construction will not have an impact. It most certainly has and will continue to do so. Employment in construction is currently off 2.6 percent over the past year and expected to fall further. Employment in related industries, including mortgage finance, is also weakening. Several other areas, including health care, education, leisure and hospitality, and wholesale trade and distribution, continue to do quite well. Defense, aerospace and the state’s key technology sectors also continue to expand.

The problems in mortgage finance are disproportionably affecting the California labor market. Nearly forty percent of recent layoffs were in credit intermediation and related activities. Through August, California has reported 42 percent more initial claims for unemployment insurance in the industry than in all of 2006. Obviously, credit market turmoil continued into September and we would expect the mass layoffs to get worse before they get better.

On a relative basis, the strongest job growth continues to be in the Inland Empire. Hiring is being driven by the burgeoning foreign trade sector. San Francisco and the greater Bay area, on the other hand, have taken much longer to recover from the last recession. San Francisco lost nearly ten percent of its nonfarm jobs in the three years including and following the 2001 recession, which hit the IT sector particularly hard. Sacramento saw the second strongest rate of improvement following the recession but hiring has slowed more recently, reflecting the relatively sharp contraction in homebuilding and mortgage finance currently taking place there.

Housing Inventory

The inventory overhang in California housing is severe at this point and has shown no signs of declining in the near-term. While the months’ supply of existing homes for sale has not reached the highs of the early 1990s after the last California housing bust, the pace of assent has them rapidly approaching those levels. The massive inventory overhang and California’s low affordability leads us to believe that activity on new homes will have to decline further from their already depressed levels and prices may have to decline substantially in order for balance to be restored in the market.

Prices will fall in both nominal and real terms. We are expecting about a 16 percent nominal drop over the next three years. The OFHEO price data that we use to trace California’s home prices excludes most homes with Subprime and Jumbo mortgages. Once these homes are included, price declines will prove to be far more severe. Unfortunately, there is no statewide price index that incorporates this data.

Outlook

California’s economy will continue to lose momentum as the housing bust unfolds. The slowest period of economic activity will likely occur between now and the middle of 2008. This period should see the bulk of the cutbacks in residential construction and related industries, such as mortgage banking. Rising foreclosures will result in larger price declines during the coming year. California will likely see prices decline in nominal terms for at least the next couple of years and in real terms a few years beyond that.

The weakness in the housing market is impacting consumer spending. Sales of motor vehicles have weakened much more in California than they have in the rest of the country. Sales are also off sharply at furniture stores and home improvement centers. Despite these declines, overall retail sales are still growing, reflecting solid income gains and a growth in tourism.

Once home construction bottoms out, economic growth will gradually pick back up, reflecting solid gains in international trade and the state’s large high technology sectors. We should see more balanced growth toward the end of the decade, with growth in business fixed investment helping drive output in the state’s IT equipment and software industries. The growing interest in green technologies is rapidly emerging as another key competitive advantage for California and could contribute meaningfully to growth in coming years.

While we expect conditions to gradually improve, the economic environment remains extremely challenging in California. High housing costs and rising energy bills are nudging many businesses and residents to neighboring states and, increasingly, to points even further out. Overall population growth has slowed significantly and will likely remain sluggish over the next few years. Slower population growth means that it will take longer to clear out the excess inventories of new homes currently on the market. A correction is underway, however, and we believe that the most painful part will be in the next few quarters.

Labor Market Has Weakened in Recent Months

California’s labor market has shown some weakness in recent months with nonfarm employment slowing to just 0.3 percent pace over the past three months. The deceleration reflects cutbacks in residential construction and mortgage finance, as well as an increasing reluctance by businesses to add staff.

California’s unemployment rate clearly bottomed in late 2006 and has risen 0.9 percentage points as the state economy took the brunt of the housing downturn and subprime mortgage market collapse in quick succession. Layoffs and job losses in both the construction and financial activities sectors are not over yet. Construction activity is still winding down throughout the state and we should see job losses accelerate later this year and early 2008. Layoffs in the financial sector took off in August and September and will take some time to work into the reported employment figures.

Coincident Index Indicates Moderate but Continued Growth

The coincident index has moderated in recent month, but is still growing solidly, climbing 2.8 percent over the past year. California’s economy has clearly experienced strong headwinds from the housing slump and more recently the mortgage market. Despite these problems the state is poised for moderate but continued growth. Population growth has slowed in recent years, but the state still added close to 300,000 people in 2006, the last year a Census estimate is available. The lack of affordable housing and a generally high cost of living continue to impede population growth.

Manufacturing exports slowed in the second quarter to just over $29 billion but remain near their recent highs. U.S. export strength on the whole should continue with a weaker dollar and strong growth abroad, as a result we would expect California’s exports will find the same favorable conditions in world markets.

Permits Are Off Sharply Since the Cycle Highs

Permits for new single family homes across the state are off sharply, down 34 percent in the last year and nearly two-thirds since the peak of the housing market. Single family permits are reaching levels not seen in more than a decade, as a severe inventory overhang plagues the California market. California housing has had and continues to have an affordability problem. While the premium that California’s home prices sell at relative to the nation using the OFHEO index averaged 11 percent between 1982 and 1998, the premium now stands at over 55 percent. Clearly this gap will need to close, at least modestly before housing will recover in the state. This convergence does not have to entirely be made of price declines in California, though we think double digit declines over the next few quarters are likely. Some of the correction will also come from slower price appreciation that the rest of the country in the out years.

Los Angeles

• The labor market remains steady in the Los Angeles area, while the unemployment rate has shown signs of bottoming out. Slow population growth coupled with modest gains in both nonfarm payrolls and household employment may combine to hold the unemployment rate near its current level.
• The size and diversity of the Los Angeles economy leave the city less exposed to the downturn in residential construction and housing that is plaguing many other parts of the state. Growth in defense and aerospace is helping offset some of the slowing elsewhere and international trade continues to grow rapidly.
• While Los Angeles may not have as high a cost of living as some California markets, such as San Francisco, the costs are still far higher than the nation as a whole. Home price affordability has made it a more expensive proposition for those considering a move to the area from less expensive markets out of state.
• Population growth, while still positive, has slowed for five straight years through 2006. Net migration has actually been negative for the last four years, as domestic emigration overwhelmed foreign immigration.
• Los Angeles is a major transportation hub for goods transiting from the Far East to the continental U.S. and increasingly from the U.S. to the Far East. The Port of Los Angeles is the nation’s largest container port and, when combined with the neighboring Port of Long Beach, ranks as the fifth largest container port in the world. These two ports moved more than ten percent of U.S. merchandise trade this past year. The strong traffic flow and shift to containerized ocean freight are creating demand for new industrial space and infrastructure.

Riverside

• The labor market appears to be weakening slightly with the unemployment rate having bottomed for this cycle, most likely. Payroll growth remains relatively firm, however, with growth rates well above the national average. Strong population growth may be contributing to the divergence, but the large number of workers who commute out of the area for work is also important. While household employment figures show nearly 1.74 million workers, the area reports just over 1.3 million nonfarm jobs, about 76 percent as many. With the vast transportation network linking Riverside to its western neighbors in the greater Los Angeles area, the two economies are closely interlinked.
• The growing importance of the region’s intermodal and transportation connections has created strong demand for industrial space and non-residential investment. Lying less than fifty miles to the east of the major ports in Los Angeles, Riverside is crisscrossed by two Class I rail systems and serves as the nation’s key distribution center for Asian imports.
• Overbuilding of new single-family homes was rampant in Riverside, as a result of the region’s rapid gains in population and employment. Building permits reached a high of nearly 60,000 units at an annualized rate in September 2005 and have since declined nearly seventy percent off that peak. Continued population gains and the relative lack of a boom in multi-family construction should help Riverside work through the glut of single-family homes faster than some other California markets.
• Population growth remains a key strength of the market, helping drive gains in retail trade, and business and professional services.

San Francisco

• While the unemployment rate has ticked-up in recent months, the labor market still appears to be in relatively solid shape. Solid yet unspectacular growth in employment continues, with both nonfarm and household employment growth outpacing the nation. The labor market was hit hard by the bursting of the tech bubble in the early part of the decade and employment growth did not return until 2005 on a sustained basis.
• Population growth also suffered in the aftermath of the tech bubble, with the population declining outright from 2002-2004. However, growth has returned to the region for the last two years, albeit at a slower pace than before. Many of the same obstacles remain for migrants looking to the Bay Area, namely an extremely high cost of living with very low housing affordability. The cost of the median home sold in San Francisco in 2007 was $827,000, which is among the highest for any metro area in the nation.
• Housing price growth has slowed in recent quarters after the second period of rapid growth in a decade. Housing prices grew at nearly a thirty percent pace in 2000, and again in 2004- 2005. While, we expect housing prices to continue to struggle for the next year or more in San Francisco, we do not see the same sized declines as we expect other areas. The market still has solid underlying support with renewed population growth and a technology sector that appears poised for an upswing in coming quarters. Land for new residential development remains scarce and entitlements are tough to come by.
• Demand for office space has been growing. Vacancy rates topped out at over 20 percent in mid 2003. Led by sharp declines in suburbs, the metro area vacancy rate fell to 8.5 percent in the third quarter, its lowest level in six and a half years.

Sacramento

• The labor market is clearly showing signs of weakness in Sacramento, unemployment rose to a 40 month high in August at 5.5 percent. In addition to layoffs in residential construction, several financial services firms have announced cutbacks recently. On the plus side, hiring has picked up in the tech sector.
• Residential construction has slowed considerably in recent months but will likely need to fall even further. Sacramento is seeing one of the largest increases in foreclosures and was one of the more active markets by speculators.
• Sacramento and the Central Valley are one of the most overbuilt markets in the state. New permits for single-family homes reached levels not seen since the mid-1990s in the wake of the last California housing bust. Housing prices have declined at an accelerating pace, quarter over quarter, for six straight quarters now and there are more declines to come.
• Population growth in the region has slowed considerably in recent years, but the region is still adding new residents at a solid pace. Sacramento, despite having a high cost of living relative to most of the country, is still affordable compared to the coastal regions of the state. This incentive will only be helped by the cities relatively early home price correction compared to other parts of the state and country.
• Government remains the cornerstone of the Sacramento economy. The government sector has traditionally played a stabilizing role in the labor force providing at least stable if not growing employment despite cyclical turns. This may at least be somewhat in doubt as tax revenue growth has slowed along with the California housing market.

San Diego

• San Diego may be more exposed to the housing market troubles than many other cities in California. Housing prices have been declining for almost a year now on an OFHEO basis, and while building activity is well off its highs it has yet to reach the lows seen in the last California housing bust in the early 1990s. San Diego may still have some room to decline over coming quarters on both the activity and price fronts as conditions will most likely get worse before they get better.
• The employment market has weakened considerably in the city this year. While, nonfarm employment continues to grow year over year, it has slowed notably, and the unemployment rate has been trending up for most of the year as well. The city does still have strong ties to the military and government contractors and this may provide some cushion on the employment front. That said it will be difficult for these factors to offset declines in construction and financial activities tied to the housing boom. These losses will get worse before they get better.
• Slower population growth may limit the rise in the unemployment rate, as housing affordability is an issue in San Diego just like most of the state. Demographics trends coupled with a slowing housing market may slow the economy to well under the pace of growth seen in recent years.
• San Diego’s key biotechnology sector continues to have strong momentum and remain a key competitive advantage for the region. Venture capital remains abundant for the industry.
• Office vacancy rates bottomed for this cycle at the end of 2005 and have risen almost three percentage points since then. San Diego’s high housing costs are causing many firms to look outside the region when they are expanding their operations.

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Published on  Mon, Oct 22 2007, 11:06 GMT

Housing Chartbook: October 2007

Tue, Oct 16 2007, 06:34 GMT
by Adam York, Mark Vitner

Wells Fargo Investments, LLC

Executive Summary

The recent turmoil in the mortgage market and near shutdown of the subprime lending market is further restricting the supply of qualified homebuyers. Recent months have seen the secondary market for subprime and nontraditional mortgages dry-up. It is nearly impossible today to sell subprime loans, stated income loans, interest-only loans, and even high quality jumbo loans into the secondary market. As a result, terms on such loans have tightened considerably.

Tighter lending standards are making it considerably tougher for potential homebuyers to qualify for a mortgage. Banks generally reported falling demand for all types of mortgages, with the sharpest drop occurring in subprime loans. With lending standards remaining tight, we have again lowered our forecast for both new and existing home sales. Sales of new homes are now expected to plunge nearly 22 percent this year, while sales of existing homes should decline 11 percent. While these drops are dramatic, it is important to remember that most of this decline has already occurred. The bulk of the correction in the housing sector is behind us.

The meltdown in the secondary mortgage market makes forecasting home sales particularly difficult. Delinquencies and defaults typically take a while to show up and probably will not top out for several more quarters. Tighter lending standards in recent months mean that credit quality and delinquencies will most likely be the worst for mortgages originated in late 2005 and early 2006. This still means that any noticeable improvement in credit conditions is, at a minimum, a few quarters away.

We have long noted that many of the problems currently plaguing the housing market can be traced back to the huge role speculators played in the housing market back in 2004, 2005 and early 2006. Speculators made demand appear much stronger than it actually was from a fundamental standpoint. The added push from speculators drove prices up to levels that priced out many buyers in California, Arizona, Nevada, the greater Washington D.C. area and areas around New York City. While these markets had the greatest speculative excesses, investors and speculators were active in markets all across the country.

What needs to happen now is for prices of new and existing homes to adjust back to levels where families earning the median household income can once again afford to buy a wide assortment of homes, particularly in Florida, Nevada and California. Price declines in these markets are likely to be fairly significant in coming quarters. For the rest of the country, price adjustments will be far more modest and most areas will simply see price appreciation slow rather than endure outright price declines.

Starts of single-family homes will likely fall sharply in coming months, as builders respond to tighter credit conditions. We still see home construction bottoming in the coming year, however, as sharp adjustments in new construction have already occurred in the parts of the country that face the greatest oversupply. After tumbling 28 percent this year, we expect starts of new single-family homes to fall an additional 11 percent in 2008. More drastic reductions simply are not needed, as most of the reduction in new home construction has been in markets where overbuilding and speculative buying were the worst.

Construction of apartments is actually picking up slightly, which should offset some of the slowing we expect in the condominium market. In total, starts of multi-family projects, which includes apartments, condominiums and town homes, are expected to be unchanged in the coming year.

For the second year in a row, sales of new homes will not fall nearly as much as construction will, which will help eat away at the oversupply of homes on the market. We expect sales of new single-family homes to fall 6.0 percent in 2008, following an 11 percent drop this past year. Sales of existing homes are expected to decline 7.9 percent. Builders will need to clear out their own inventories before inventories of recently built existing homes will begin to clear. From a national standpoint, we expect the supply and demand of housing to be roughly in balance by the end of the year, which should allow for some modest improvement in both sales and new construction in 2009.

Applications Bounce and Level-off

Applications may have received some lift in recent months from tighter lending standards, as many applicants are filling out more applications looking for a willing lender. The increase in multiple application files makes it a bit more difficult to gauge actual demand for mortgages.

Applications for adjustable rate mortgages have cooled off considerably. Part of the decline simply reflects the small gap that currently exists between fixed rate and adjustable rate mortgages. Lenders are also curbing their offerings of adjustable rate products, shedding many of the more exotic mortgage products.

Affordability Hit Hard by Rising Mortgage Rates

Affordability is still stretched in many parts of country. Sales in areas where prices rose the fastest, such as Florida and California, are currently seeing some of the largest declines. Home prices are beginning to correct and job and income growth remain solid. Affordability has risen slightly from its lows. Unfortunately, rising mortgage rates are cutting into this improvement, and tighter lending standards are another problem. The interest rate on jumbo mortgages has also risen, which is compounding the problem in higher priced and second-home markets. The cost and availability of insurance is another limiting issue for many coastal markets.

Starts Fall Further on Credit Woes

Recent credit woes have sent housing on another downswing. The impact on starts will be more muted than some are expecting as most builders are now ramping down production as fast as they can. Inventories are still too high, however, particularly in Florida, northern Virginia, Arizona, Nevada and parts of California. There are also some bright spots, including Houston, Charlotte, Raleigh, Nashville, and Austin in the South, and Seattle and Portland in the West. While we still expect starts to fall further in coming months, we should see a bottom by the middle of next year.

Permits Reach Multi-year Lows

Declines in permits are beginning to show improvements in year-over-year change figures do to lower comps in late 2006. These improvements should give little comfort to investors, except to note permits are approaching a definitive floor in some of the hardest hit markets. Several states have seen extremely large declines. Florida has seen permits tumble 43 percent over the past year and 68 percent from their cyclical peak. In Nevada, permits are down 49 percent year to year and 71.5 percent from their peak. Permits for new homes in California are off 34 percent over the past year and 66 percent from their peak. How much further can they fall?

New Home Sales Retrace Bounce and Then Some

New homes sales reached a new business cycle low in August, as credit concerns and market volatility weighed on the minds of consumers. The drop in sales likely does not capture the extent of how much demand has weakened. The new home sales figures do not take cancellations into account, and cancellations soared in August, as tighter credit conditions made it tougher for would-be homebuyers to qualify for a mortgage. Fortunately, inventories are now falling and should continue to retreat over the next few years, as housing completions are now steadily declining. We expect to see considerable improvement in inventories over the course of 2008.

Existing Home Sales Continue Slide

Since rising early this year, existing home sales haven fallen back almost 18 percent and we would expect these declines to continue for several more months. We do not expect existing home sales to bottom out until late spring at the earliest.

Existing home inventories remain high and part of this glut reflects new homes purchased by speculators that had expected to flip them before construction was completed. Many investors are unable to cut prices much from current levels while builders can cut their prices on competing homes or add amenities, which is one reason existing home inventories remain high and prices remain sticky.

Price Indices Still Show Split Opinion

The OFHEO index, our preferred measure of housing prices, continues to show positive appreciation, year over year. Eighty-percent of the U.S. population, covered by the survey, lives in a metro area where prices are up, year over year. We think this indicates less of a wealth effect on spending than some are forecasting in coming quarters. The S&P/Case-Schiller Index of 20 major markets shows a more severe decline, with overall prices falling 3.9 percent over the past year. With the exception of Detroit, the largest price declines are in markets where prices had previously surged and where investors made up a larger proportion of earlier home purchases.

Delinquencies Continue to Rise

Mortgage delinquency rates have risen in recent months, particularly for adjustablerate subprime loans. We expect delinquency rates for such loans to rise at least through the middle of next year, as many of the subprime loans made after the housing market peaked two years ago have experienced a high level of early payment defaults. Delinquency rates on fixed-rate subprime loans and prime conventional loans have risen far less. ABX spreads have moved largely sideways but remain at extremely wide levels, which means it remains tough for lenders to sell mortgages into the secondary market.

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Published on  Tue, Oct 16 2007, 06:34 GMT

Recent Bond Market Developments: Adjustment or Trend?

Mon, Jun 18 2007, 07:35 GMT
by Mark Vitner, John Silvia

Wells Fargo Investments, LLC

This past week’s sell off in the bond market sent the interest rate on the 10-year Treasury bond up to 5.31 percent, which is more than a 40 basis points higher than it was three weeks ago. The trigger for the run-up in yields has been the sudden turnaround in the economy’s near-term growth prospects, which has thrown cold water on any notion that the Fed would cut interest rates this year or that the economy was headed for recession. The yield curve is now upward sloping, indicating that the investors expect economic growth to accelerate.

Is the rise in rates a one time adjustment or a signal of a sustained trend? Our explanation is that the 5.31 percent threshold will hold for now and that yields may even slide back toward 5.00 percent over the next few weeks. One thing is certain, however. Interest rates were clearly too low three weeks ago. Back then the market was still focusing on the fallout from the unwinding of the housing boom. The collapse of the subprime lending market, the impending reset of adjustable rate mortgages and the rising tide of foreclosures were widely touted as threats to consumer spending and overall economy growth during the second half of the year.

Today the economic outlook has improved substantially. Real GDP growth is now widely expected to rise at a 3.0 percent or better pace during the second quarter. Our own forecast calls for a 3.8 percent increase. Growth during the second half of the year is likely be around three percent, which we believe is close to the economy’s long-term sustainable growth rate.

Tuesday’s sell-off was largely driven by the poor auction results for the Treasury’s 10-year note. By the end of the session, the yield had risen to a 5-year high of 5.26 percent and the yield drifted up to 5.31 percent in after-hours trading.

By Wednesday, it appeared the worst of the bond market rout was over. Retail sales rose much faster than expected in May, surging 1.4 percent overall and 1.0 percent after excluding motor vehicles and gasoline. Those stronger numbers along with a small upward revision to the April data mean that real personal consumption expenditures probably climbed at around a three percent pace during the second quarter. But rather than selling off on this news, the bond market rallied and yields drifted down toward 5.20 percent.

The drop in yields that followed the stronger retail sales figures is encouraging. For now, 5.31 percent likely marks the upper end of the trading range for the 10-year note, while 5.00 percent likely marks the lower end. Back in early May, the yield on the 10-year was around 4.60 percent.

The rise in long-term interest rates and return of a positively sloped yield curve likely signals increased expectations for economic growth and not increased concerns about inflation. Another way of looking at this is to look at the yield on the 10-year Treasury Inflation Protected Securities (TIPS), which have risen 60 basis points over the past six weeks. Since the spread between the 10-year Treasury note and the 10- year TIPS has not changed materially, all of the increase in the TIPS yield is due to higher real interest rates, or what economists refer to as the opportunity costs of money. In other words, investors expect economic growth to improve.

The Fed’s Beige Book also had some bond friendly news in it. The economy is reported to be growing modestly and higher energy prices do not seem to be spilling over into the prices of other goods and services or to be impacting inflation expectations. The tone of the Beige Book also appears to much more subtle than the gains we have seen in most of the major indicators this past months, including the ISM report, the employment data, and the May retail sales report.

With so much action earlier in the week, the bond market barely budged after the long awaited Consumer Price Index (CPI) number. The headline CPI came in about as expected, with higher energy costs driving the overall CPI up 0.7 percent. The gain puts the CPI up at a 7.0 percent annual rate over the past three months, almost entirely due to a spectacular surge in gasoline prices. Gasoline prices rose 10.5 percent in May and are up at a 168.2 percent annual rate over the past three months.

From the bond market and Fed’s perspectives, the key question on the inflation is how much of the surge in gasoline prices has passed through into the prices of other goods & services and how has that influenced inflation expectations. So far the answer to this question has been surprisingly little. The core CPI rose just 0.1 percent, with modest gains in housing costs, declines in prices for apparel and new motor vehicles, and unusual restraint in prices of prescription and nonprescription drugs. The ongoing correction in the housing market should continue to cut into rent and owners’ equivalent rent, which make up close to 40 percent of the core CPI. As a result, we should continue to see only modest gains in core inflation.

Friday’s CPI report was the last piece of data that presented a significant risk to the bond market, and the modest 0.1% growth on the core was reassuring to the bond market. Most of the reports we will receive over the next three weeks should be relatively market friendly. The housing data are widely expected to weaken and we should see a reversal of last month’s peculiar rise in new home sales. We also suspect we will see at least a partial reversal in some of the recent strength in the regional Fed surveys. The next big unknown for the markets may be the advance report on durable goods, due out on June 27, which is just before the Fed’s June 27/28 FOMC meeting.

A few weeks back we wrote in our weekly commentary that ‘there are no monsters under the bed or in the closet.’1 The piece referred to what we felt were irrational fears about the correction in housing market, the impending reset of adjustable rate mortgages, and the apparent lack of capital spending. The financial markets have finally gotten the message. Yields were too low three weeks ago because concerns about the economy were considerably overblown. We now see the market turning full circle, with optimism about the economy just a bit over the top.

Let’s start with the economic outlook. We boosted our forecast for second quarter GDP the very same day first quarter growth was revised down by 0.7 percentage points to 0.6 percent. A good part of that downward revision was due to a larger drawdown in inventories and a wider trade deficit during the first quarter. The current quarter will see a reversal of these trends, with inventories and trade adding to growth. We boosted our forecast 0.3 percentage points to 3.8 percent.

Does 3.8 percent real GDP growth in the second quarter represent a major change in the economic outlook? The answer is, somewhat surprisingly, no. If you average first quarter growth with our estimate of second quarter growth it comes to around 2.2 percent, which is roughly equivalent to where the economy has been the last four quarters. The biggest change, however, is what comes later in the forecast. After decelerating for the better part of a year, the economy is now reaccelerating. The bulk of the drag from the housing slowdown is now behind us and we are finally beginning to see some encouraging signs in business fixed investment.

There is now considerably less downside risk to the economy and this has greatly diminished the chance that the Fed will cut short-term interest rates this year. We believe the chances of a rate hike, however, are pretty slim. Much of the renewed optimism about the economy stems from the better than expected ISM manufacturing and non-manufacturing surveys, as well as regional surveys such as the Chicago Purchasing Managers’ Index.

The ISM and regional purchasing managers’ surveys are diffusion indices. They measure the breadth of improvement or deterioration in the economy not the magnitude. A reading above 50 means that more purchasing managers see business conditions improving than see conditions weakening. Since so many purchasing managers were unduly pessimistic about the economy a few months ago, particularly on the manufacturing side, it was relatively easy for these series to bounce back in May. Conversely, today’s optimism about the economy will make it harder for the ISM and regional indices to post additional gains in June and July. We look for these reports to give back some of their recent gains in coming months, which may provide some relief for the bond market.

Most other economic indicators, including employment and retail sales, will also likely soften a bit during the summer. Our current forecast for third quarter real GDP calls for a gain of around 2.8 percent and we still feel comfortable with that forecast.

We are in the process of updating our interest rate forecast to incorporate the latest moves in the bond market. Our June forecast was largely put together in late May and early June, when the yield on the 10-year Treasury note was nearly 40 basis points lower than it is today and the yield curve was essentially flat. Forecasting interest rates is always hazardous duty, particularly in the midst of a market rout.

Alan Greenspan noted in a speech to the Commercial Mortgage Securities Association Tuesday that bond yields were likely in the midst of a cyclical upturn that could take interest rates higher than many people currently expect. We agree with this view but caution investors to remember that there are some seasonal and technical pressures that likely magnified the most recent jump in rates. Oftentimes we see some upward pressure on bond yields after taxes are paid on April 15. This year, with large numbers of households being hit by the Alternative Minimum Tax was no exception, leaving a little liquidity in the marketplace.

Economic growth is likely to strengthen in coming quarters, as business investment ramps up and the drag from the housing slump diminishes. With little slack in the economy, inflation is unlikely to decelerate to any significant degree but we do not see it becoming a major problem in 2007 either. In this environment, the Fed will likely remain on hold through the rest of this year and will not tighten until they see some sign that housing has bottomed out. We think that will put the first tightening in the spring or early summer of next year. The yield curve should retain its positive slope, which it only recently regained.

The yield on the 10-year Treasury note has largely been below nominal GDP growth for the past 5 years, which is not sustainable. Remember that an interest rate has three components: opportunity cost, which we believe is best represented by nominal GDP; the time value of money, which was consistently around 135 basis points before the Fed and other central banks began to flood the economy with liquidity in the wake of the Asian Economic crisis in the late 1990s; and a risk premium, which is irrelevant for Treasuries. The U.S. Treasury cannot go out of business.

As we noted back in our March 6 piece, March Madness and Global Liquidity,2 longterm Treasury yields below nominal GDP clearly do not make sense. What this literally says is that if you could borrow enough money, you could buy the entire U.S. economy and make money on the spread, the mother of all arbitrage opportunities. Maybe this is why we have seen so much hedge fund and private equity activity.

We now expect the yield on the 10-year Treasury note to either equal nominal GDP or slightly exceed it. With real GDP likely to expand at around a 3 percent pace and inflation likely to rise at a little over a 2 percent, a reasonable expectation for the 10- year note in the near-term would be somewhere between 5.00 percent and 5.50 percent through the end of this year.

Yields should generally rise over the forecast period, although we will almost certainly see some seasonal pullbacks along the way. A year from now we expect the yield on the 10-year note to be closer to 6 percent and expect the 10-year note to end 2008 at slightly above that level. This is a much different environment than we have become accustomed to in recent years but is generally consistent with an economy moving into the mature phase of the business cycle, when there is less slack available in the U.S. and global economies.

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Published on  Mon, Jun 18 2007, 07:35 GMT

Housing Chartbook − June 2007

Mon, Jun 11 2007, 15:33 GMT
by Jason Schenker

Wells Fargo Investments, LLC

Global Growth Outlook

Global growth is likely to slow this year to 4.3 percent from 5.4 percent last year. Although we believe the growth rate this year will be slower year over year, it is still above-trend historically. Economic growth so far this year has been somewhat of a mixed bag, with some economies exhibiting moderation and others continuing to remain strong. The slowing of growth is largely the result of central bank moves to raise policy rates across a number of economies. While emerging markets and developed economies could be a mixed bag growth-wise this year, inflationary pressures are likely to ease in most economies. U.S. inflationary concerns are, according to the May FOMC minutes, “the predominant policy concern” of the Fed. Despite a slowdown in growth in the United States, we find that the Fed has likely pulled off a soft landing, and that growth is likely to rebound after the first quarter. At the same time, globally, we also see a similar soft landing scenario coming to fruition.

United States Growth Outlook

The drags on U.S. GDP growth probably will diminish this year. Housing is likely to be less of a drag, as are the auto and trucking sectors. With consumer spending bolstered by a low unemployment rate and continued job gains, we expect U.S. GDP to be around 2.2 percent for all of 2007. This is lower than the 3.3 percent real GDP growth rate seen in the United States last year and also lower than our forecasted real GDP growth rate for 2008 of 3.3 percent.

Fed Expectations

After depreciating earlier this year, the dollar has stabilized versus most major currencies over the past month due in part to shifting expectations about Fed policy going forward. Statements by Fed Chairman Bernanke and positive economic indicators point to strength—and future Fed rate hikes. Our forecast released this month includes revisions to our Fed expectations. We were previously forecasting one rate hike in 2008, but we have now revised our forecast to include two rate hikes. Consumer confidence, ISM surveys, a low unemployment rate and a number of other economic indicators point toward potential Fed hikes next year.

Dollar Stabilization

As little as a month ago, many investors expected the Fed to cut rates this year. However, stronger-than-expected data over the past few weeks have led many market participants to conclude that the U.S. economy does not need an easing of monetary policy. U.S. bond yields and Fed futures have risen, lending some support to the greenback. Although the dollar could rally in the near term, we do not believe that sustained appreciation is imminent. Indeed, we continue to project that the greenback will trend lower over the next few quarters.

As is widely known, the United States continues to post massive current account deficits that need to be financed via net capital inflows. Although foreign purchases of U.S. securities remain at high levels, they appear to be trending slowly lower. At the same time, U.S. purchases of foreign securities have jumped recently, meaning that net capital inflows have weakened. Lower net capital inflows have put downward pressure on the greenback.

Interest Rate Differentials

We believe interest rate differentials will need to move back in favor of dollar assets for a sustained dollar rally to take place. While Fed rate hikes are still about a year away, other central banks, which generally have lagged the Federal Reserve in this tightening cycle, will likely continue to hike rates, and with good reason. Growth rates in most foreign economies remain very solid, and it is hard to make a convincing case that global financial conditions are restrictive at present. Although inflation rates in most foreign economies remain benign, foreign central banks may take preemptive steps to ensure that inflation rates do indeed remain under control. Therefore, rates abroad should continue to head higher at a modest pace.

The Eventual Swing Back in the Dollar’s Favor

Looking far ahead, our forecast calls for the dollar to strengthen in the second half of next year. We generally try to refrain from picking turning points in dollar exchange rates far in the future. However, the greenback has been depreciating on a trend basis for five years, and it is bound to turn around sooner or later. Besides, the turnaround we project is consistent with our expectations that the FOMC will tighten anew next year. As interest rate differentials move back in favor of the dollar, the relative attractiveness of dollar assets will begin to improve, which should lead to stronger capital inflows. To reiterate, we believe that the dollar will weaken further before it begins a sustained turnaround. In our view, higher rates in the United States are needed before a trend change in the dollar can begin. Although the FOMC still seems to be a long way from raising rates.

Energy and Metals Prices Settling into a Range

As the dollar has settled into a trading range against most major currencies, so, too, have the prices of most metals and energy commodities. Although oil remains elevated by numerous geopolitical concerns, the price has been relatively rangebound for months. The prospect that oil prices may have settled in for a number of years in the $60-$65 range seems a likely possibility. Retail gasoline prices are a major concern in the United States, but retail prices could very well be more moderate next summer, but are also likely to be higher this coming winter than they were this past winter. This means that consumer price inflation could be subject to less upward pressure at the headline level as those gasoline prices ease on a year over year basis next year. Indeed, the threat to U.S. inflation levels next year comes largely from continued increases in capacity utilization and a continued tightening of the labor force.

In the near term, the price of West Texas Intermediate crude oil is likely to continue trading at a discount to Brent crude. However, we see the crude oil premium as narrowing in coming quarters. In the longer run, natural gas prices are likely to increase on-trend as a result of changes in carbon emissions regulations. The longrun increase in the price of natural gas and elevated crude prices are likely to support metals prices in coming quarters. While most commodity prices might not surge in coming quarters as they have done in recent years, they are likely to remain high historically.

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Published on  Mon, Jun 11 2007, 15:33 GMT

Housing Chartbook − June 2007

Fri, Jun 8 2007, 15:56 GMT
by Adam York, Mark Vitner

Wells Fargo Investments, LLC

The Drag from the Unwinding of the Housing Boom Is Fading

Federal Reserve Board Chairman Ben Bernanke noted this past week that “the slowdown in residential construction now appears likely to remain a drag on economic growth for somewhat longer than previously expected.”1 While the data from the housing sector continues to be mixed, we have not materially changed our view on the housing sector. We continue to believe that the bulk of the drag from the unwinding of the housing boom is behind us and see a good chance that home sales will bottom out in the next few months. Housing starts and residential construction, however, will continue to decline through at least the end of this year, and may not hit bottom until early 2008.

Chairman Bernanke’s remarks to the International Monetary Conference noted that the 16.3 percent reduction in residential construction over the past year had shaved about one percentage off of real GDP growth. On a sequential basis, residential construction declined at an 11.1 percent annual rate during the second quarter of 2006, 18.7 percent pace in the third quarter, 19.8 percent rate in the fourth, and at a 15.4 percent pace in the first quarter. We expect residential construction to continue decline in coming quarters but for the declines to become progressively smaller.

In terms of its impact on real GDP, the decline in residential construction has shaved 0.9 percentage points off GDP growth. Put differently, if residential construction spending simply remained unchanged, real GDP growth over the past year would have been 2.8 percent instead of 1.9 percent. Such comparisons by economists often seem confounding to the general public but actually provide a great deal of information. As the decline in residential construction diminishes, overall economic growth will likely ramp back up to this higher underlying rate, particularly since, as the Fed has often noted, we have not seen any significant spillover from the housing slowdown into other areas of the economy.

The economic picture outside of the housing sector is even brighter when you take into account that inventory liquidations have sliced another 0.4 percentage points off growth during the past year. That puts the underlying rate of real GDP growth at better than 3 percent, which probably explains why employment, income and consumer spending have held up so well amid the slowdown in the housing sector.

Solid economic growth will eventually pave the way for a recovery in the housing sector. Remember that housing does not drive the economy. The economy drives the demand for housing. The demand housing is a derived demand, which is derived from the underlying growth in the economy. Stronger job and income growth will eventually lead to a rebound in home sales, which will help chip away at the inventory of unsold homes. The process is just now getting underway.

We have slightly reduced our forecast for sales and new construction in 2007 but the outline of our forecast remains virtually the same as it has for the past several months. We expect home sales to bottom out this summer, at levels 3 to 5 percent lower than they were in early spring. Discounting by homebuilders and the widely reported rise in home foreclosures will likely lead larger price declines in markets where speculative activity was rampant back in the summer of 2005. These price declines will help restore housing affordability in some of the higher priced markets, although rising mortgage rates will offset some of the price drop.

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Published on  Fri, Jun 8 2007, 15:56 GMT

Turkish Chartbook May 2007

Fri, May 25 2007, 10:03 GMT
by Jason Schenker

Wells Fargo Investments, LLC

• Real GDP growth in Turkey has moderated in recent quarters. Growth in the fourth quarter of 2006 was 5.2 percent, and represented a continued expansion in Turkish GDP (Exhibit 1).
• Unlike other European economies, however, the unemployment rate in Turkey has been on the rise, and is now at 11.4 percent (Exhibit 2). At the same time, inflation is on the rise and is currently over 10 percent (Exhibit 3).
• The high rate of Turkish inflation has necessarily provided the back-drop for relatively high Turkish Libor rates (Exhibit 4). While debate rages about Turkish membership in the European Union, there is no debating Turkey's current economic qualifying potential (or lack thereof) for the European Monetary Union, which requires interest rates and inflation rates to be much closer to the Euro-zone averages.
• Industrial production in Turkey has also moderated in recent months (Exhibit 5). If the European and broader global economy continue to see slower growth rates, it is likely that Turkish industrial production and growth will slow as well.
• Recent improvements in the Turkish trade deficit (Exhibit 6), and the gaping U.S. current account deficit, have allowed the Turkish lira to gain against the greenback in recent months (Exhibit 7). Furthermore, we look for the lira to continue to strengthen on-trend against the dollar in coming quarters, especially if the Turkish Central Bank attempts to contain inflationary pressures (Exhibit 8). Risks to our TRY outlook, however, are noteworthy.
• Aside from the potential negative knock-on effects associated with slowing European and global growth, there are significant risks associated with the upcoming Turkish elections this summer (which have been pulled-forward from November). Political risks stem from the military’s historical duty to enforce the secular nature of the Turkish government, even if this means implementing a military coup d’état or other intervention, which it has done four times over the last 50 years.

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Published on  Fri, May 25 2007, 10:03 GMT

Will Hong Kong Follow China and Kuwait?

Fri, May 25 2007, 09:51 GMT
by Jay H. Bryson

Wells Fargo Investments, LLC

China and Kuwait Make Changes to Their Exchange Rate Regime

What do China and Kuwait have in common? If you answered that they both recently made changes to their respective exchange rate regimes, then you are right on the money. On Friday May 18, China widened the daily fluctuation band of the yuan/dollar exchange rate from 0.3% to 0.5%, which, in theory, gives Beijing the ability to speed up the rate of renminbi appreciation that has been painfully slow to date.1 Three days later, Kuwait dropped the fixed exchange rate of the Kuwaiti dinar versus the U.S. dollar to a peg based on a basket of currencies. Thus, both the renminbi and the dinar could now move more against the dollar than in the recent past.

When we look around the world, there are not many currencies that remain fixed to the dollar. There are the other countries of the Gulf Cooperation Council, and Kuwait’s decision to move to a peg based on a currency basket raises the probability that some of these countries may follow suit.2 Another major economy with a fixed exchange rate is Hong Kong, which has effectively maintained a fixed value of the Hong Kong dollar to the U.S. dollar since 1983.3 Could Hong Kong be in line to make a change to its exchange rate regime?

Cyclical and Secular Reasons for Currency Appreciation

Before we attempt to answer that question, let’s quickly review why China and Kuwait each made a change to its respective exchange rate regime. Although the Chinese government did not offer an official explanation for its move, we have our hunches. First, a faster rate of appreciation would serve China’s economic interests. As shown in Exhibit 1, CPI inflation in China is on the rise again, and faster exchange rate appreciation would help to restrain inflationary pressures. Indeed, Chinese officials worry about overheating. Second, Beijing’s geopolitical interests are served by widening the exchange rate band. The Bush administration and many U.S. lawmakers have been calling on China to speed up the pace of renminbi appreciation. With a delegation of high-level Chinese officials on its way to Washington this week, the timing of last week’s announcement is no mystery.

Kuwait’s decision to change its exchange rate regime from a dollar peg to a peg based on a basket of currencies also was done because of economic reasons. Exhibit 1 shows that CPI inflation in Kuwait has consistently exceeded the central bank’s target of 2% over the last three years. About one-third of Kuwait’s imports come from the European Union. The depreciation of the dollar vis-à-vis the euro over the past few years, which has resulted in dinar depreciation versus the euro, has raised import prices, thereby helping to feed inflation. By pegging the dinar to a basket of currencies rather than exclusively to a weakening dollar, Kuwaiti authorities hope to reduce imported inflation.

Moreover, China and Kuwait are both experiencing fundamental economic changes that bolster the economic case for real currency appreciation. Kuwait is a resource-based economy whose chief export (petroleum) has experienced a price boom over the past few years. Kuwait’s current account surplus has shot up to about 40% of GDP. Money is just pouring into the country, and the sound economic policy response is to allow the currency to appreciate on a real basis. Likewise, the Chinese economy is undergoing a long-run structural transformation. As the productivity gap between China and the rest of the world narrows, the currency should appreciate.

Case for Currency Appreciation in Hong Kong Not as Clear Cut

With that overview in mind, let’s return to the original question. Could Hong Kong make a change to its exchange rate regime? Although anything is possible, we think the probability of a change is very low, at least in the foreseeable future. First, inflation in Hong Kong is not much of an issue at present (see Exhibit 1). The low rate of inflation over the past three years follows nearly six years of deflation. Indeed, the overall level of consumer prices in Hong Kong remains more than 10% below the peak in 1998.

Moreover, there are not the same secular reasons for currency appreciation in Hong Kong as there are in China and Kuwait. Yes, real GDP growth in Hong Kong has been strong over the past few years, due in part to robust growth in mainland China.4 However, the structure of the Hong Kong economy is much closer to the U.S. economy than it is to either the Chinese or Kuwaiti economies. That is, Hong Kong is a developed economy that is driven almost exclusively by services, not by resource extraction or a booming manufacturing sector. The economic rationale for real currency appreciation in Hong Kong is not as clear cut as it is in China and Kuwait.

Finally, Hong Kong’s fixed exchange rate to the U.S. dollar has served it well over the past twenty years. The old American saying of “if it ain’t broke, don’t fix it” may apply in the case of Hong Kong’s exchange rate regime. Therefore, we expect that the Hong Kong Monetary Authority will maintain the effective peg of the Hong Kong dollar to the U.S. dollar for the foreseeable future.

However, that does not mean the peg is forever immutable. As Hong Kong’s economy becomes even more integrated with the economy of the mainland, an alteration of the exchange rate regime becomes more likely. Perhaps Hong Kong authorities will someday decide to tie their currency more closely with the yuan by, say, pegging to a basket of currencies that includes the yuan.

In the longer-run there is also the possibility that the Hong Kong dollar will someday simply cease to exist. China will regain full sovereignty over Hong Kong in 2047. Will Beijing allow one city in China to retain its own currency? Probably not. The Hong Kong dollar may not even make it 40 years longer. As the renminbi becomes convertible, Hong Kong residents may start to transact in yuan instead of Hong Kong dollars. To paraphrase General Douglas MacArthur, the Hong Kong dollar may “just fade away.” To reiterate, however, the Hong Kong dollar will be a viable currency for the foreseeable future, and it very likely will remain pegged to the U.S. dollar at its current exchange rate for some time.

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Published on  Fri, May 25 2007, 09:51 GMT

Mexican Chartbook May 2007

Thu, May 24 2007, 07:14 GMT
by Jason Schenker

Wells Fargo Investments, LLC

• Growth in Mexico, like growth in the United States and elsewhere, has slowed in recent quarters. The downshift in Mexican growth, however, has been pronounced in recent quarters (Exhibit 1). We expect growth in Mexico in coming quarters to pick-up, continuing through 2008 (Exhibit 9). There are, however, some downside risks to Mexican growth in the near-term.
• Mexican data point to slowing growth across a number of sectors. In recent months, industrial production in has slowed (Exhibit 3), as has retail sales growth (Exhibit 4). Furthermore, while the unemployment rate has held relatively stable around 4 percent (Exhibit 5), slowing growth across sectors could result in a rise in the unemployment rate.
• Recent inflationary pressures in Mexico have been relatively contained historically (Exhibit 2). The combination of slower growth and moderate inflationary pressures has kept Mexican long- and short-rates flat (Exhibit 6).
• Because there is often discussion of the correlation between the Mexican peso and commodities, analysts often look at the CRB index as a proxy. However, we have found that the correlation with MXN is not that strong (Exhibit 7).
• To better gauge what moves MXN, we did some regression analyses and found that about 90 percent of daily peso variation can be explained by the daily price moves of (in order of importance) silver, crude oil and lead (Exhibit 8). This makes sense, since Mexico is the world’s second largest producer of silver, fifth largest producer of crude oil and fifth largest producer of lead. These commodities are key drivers for Mexico, which wields significant weight as a primary resource exporter.
• Because the Fed is likely to remain on hold for the rest of the year, and the U.S. has a wide current account deficit, we see gradual dollar depreciation against most major currencies in coming quarters – including the Mexican peso (Exhibit 9). Downside risks to the peso and the Mexican economy lie with an unanticipated slowing of the global economy and fall in commodity prices, neither of which we are forecasting.

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Published on  Thu, May 24 2007, 07:14 GMT

Supervisory Challenges at the Mid−Cycle of the Economic Expansion Nov. 6, 2006

Tue, Nov 21 2006, 17:36 GMT
by John Silvia

Wells Fargo Investments, LLC

Sustained, below trend, real economic growth remains the dominant theme for the outlook and yet, beneath that umbrella lies significant changes in the distribution of that growth and the perceptions of financial risk. At the sector level, differences in the pace of growth would suggest alterations to the perception of risk. However, risk spreads do not appear to be reacting to economic fundamentals. Currently the biggest challenge to bank supervisors appears to be to convince private sector agents that perhaps bank regulators are not as good as private agents have come to believe they might be. Perhaps credit risks are greater today than currently discounted in the “age of the Great Moderation?”1

In our presentation today we will first review the economic outlook. Second, we cover the economic fundamentals underlying that outlook along with the associated measures of credit risk. Finally, we will contrast those economic and risk measures and draw observations on the supervisory challenges in the year ahead.

• Economic Outlook: Below Trend Growth, the Inverted Yield Curve and a Smaller Margin of Error
• Key Indicators for Growth
• Sector Review
• Inflation: Defining the Limits to Non-inflationary Growth
• International Outlook: Downward Pressures on the Dollar
• Asset Pricing and Risk
• How Has Diminished Volatility Made the Job of Regulators More Difficult?
• Corporate Profits and Credit Risk Assessments
• Summary and Conclusions

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Published on  Tue, Nov 21 2006, 17:36 GMT

A Short Tribute To Milton Freidman (1912−2006)

Fri, Nov 17 2006, 11:08 GMT
by Mark Vitner

Wells Fargo Investments, LLC

I first became acquainted with Milton Friedman in the spring of 1973, when I was ten years old. I remember asking my father why the price of candy bars had risen from 10 cents to 15 cents. At the time, I was on a fixed income of 50 cents a week and my potential candy bar consumption had been cut by two thirds. I remember asking my father why the president could not simply ask the candy bar manufacturers to lower their prices by a nickel or why he could not order everyone to lower their prices by a nickel. While my father was a wise man, rather than try to explain an economics course to me he suggested that I go to the library and checkout a copy of Milton Friedman’s Capitalism and Freedom. From there, my life long love of economics began.

Friedman’s greatest contribution was to take theoretical economic concepts and apply them to real world problems. He did this in such a way that a motivated ten year old could understand them. Most of Friedman’s proposed ideas were once thought to be far fetched. Many are in use today, such as an all volunteer military, tradable pollution credits, school choice, floating exchange rates, removing the interest rates ceilings on bank accounts and the notion that the growth rate of the money supply has an impact on the rate of inflation.

His books, particularly Free to Choose, helped shape the Reagan Revolution during the 1980s that helped turn around a moribund economy that many of the “brightest minds in America” had already written off. Some policies, such as removing price controls on domestic oil production, were put in place immediately, while others, such as reducing and simplifying tax policy and welfare reform are still very much a work in progress. His theories broadly shaped the battle on inflation that Paul Volcker and Alan Greenspan so skillfully executed. The net result of these policies has been the strongest run of economic growth in world history and a remarkable reduction in the rate of inflation.

I had the good fortune of meeting Milton Friedman around twenty years ago at the National Association of Business Economists meeting in San Francisco. Dr. Friedman was there to receive the Adam Smith award. At the time, I had been an economist for about three years and brought a copy of his seminal work A Monetary History of the United States for him to autograph. When I first approached Dr. Friedman and his wife Rose, I must confess they seemed a bit annoyed that I would bother them for an autograph. But as soon as I let him know that I had studied under one of his favorite students, Richard Timberlake, he smiled broadly and quickly took the book and flipped through it to see what I had highlighted and underlined. We had a short conversation about chocolate bars and inflation and he allowed me to have our picture taken together.

Milton Friedman will be remembered as one of the greatest economists of all time, along with such greats such as Adam Smith, David Ricardo, Ludwig von Mises, John Maynard Keynes, and Fredrich Hayek. While most famously known as the father of monetarism, his ideas shaped entire schools of economics and will continue to be put into use by future presidents and policymakers.

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Published on  Fri, Nov 17 2006, 11:08 GMT

Holiday Sales – 2006

Thu, Nov 16 2006, 12:28 GMT
by Gina Martin, Mark Vitner

Wells Fargo Investments, LLC

The Holiday Season Is Upon Us

Halloween is over, so the holiday music is playing, the online shopping promotions have begun, and forecasters are releasing their best guesses as to how the holiday season will turn out this year. There seems to be about an even split so far between the pessimists, who believe still-high gas prices and struggling sales at discount chains will be too much to overcome, and the optimists, counting on recent strength in wage numbers to help pull shoppers into malls. We’d like to throw our hat into the optimist camp - Holiday 2006 looks like it will be a jolly one for the nation’s retailers. Despite a tough comparison to a very strong season last year, we expect sales1 in November and December to grow 7.4 percent this year

• Make Way – Wages Coming Through
• Sector By Sector – Clothing Stores and Online Retail to Shine
• Housing Market and No Hurricanes Spell Trouble for Some Retailers
• Gift Cards Also a Drag
• General Merchandisers - Still a Key Component
• Department Stores Back in Vogue?
• Merchants in the South and West Will Ring Up the Strongest Sales
• Discussion

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Published on  Thu, Nov 16 2006, 12:28 GMT

NAICS vs SIC− October 2006

Wed, Oct 25 2006, 16:31 GMT
by Adam York

Wells Fargo Investments, LLC

Are We in Even Better Shape Than the Data Suggest?

Executive Summary

It has been five years since the U.S. Census Bureau converted the inventory and sales data from the Standard Industrial Classification (SIC) basis to the new North American Industry Classification System (NAICS) basis.1 When the new system was introduced it served to push up the inventory-to-sales ratio for all businesses. The major impact was in the retail sector, where the ratio increased 0.15 on average across the dual reporting period; slight increases were seen in manufacturing while little impact was seen in the wholesale sector. The effects of the change were frequently discussed in the immediate wake of the conversion to NAICS and the release of back data for comparison in 2001. Now, we felt it time to revisit the data in light of our current position in the business cycle and consider what the data suggest for the economy going forward.

• The Loss of Historical Data
• Using the Modeled Inventory-to-Sales Ratios
• Stalled Trend
• Discussion

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Published on  Wed, Oct 25 2006, 16:31 GMT

Energy Forecast Chartbook − Q4 2006

Mon, Oct 16 2006, 07:08 GMT
by Jason Schenker

Wells Fargo Investments, LLC

• In our piece from July entitled Energy: Iran, Forward Curves and Forecasts we substituted a standard energy chartbook with a piece focused on the argument that Iran had no intention of cutting oil exports. We made the claim that Iran would become a non-issue, and at that point the price of crude would fall back to the $55 - $60 per barrel range (Exhibit 2). Now, with Iran having faded into the background, the price of oil has indeed retreated to the range we predicted. With the onset of the fourth quarter, we find energy prices facing significant downward pressure. Inventories are high, economic growth is slowing in the U.S. and abroad, the hurricane season was quiet and growth is slowing.
  
  
• The biggest change in the energy market has been the nature of the risk premium. The current price of crude is a function of supply and demand dynamics – in the present and in the future. Now, in lieu of a future disruption of supplies from Iran that could push prices to record highs, we now find a market pricing in some downside demand risk stemming from the likelihood of slower growth. We expect an economic soft landing, in which case commodity prices may retain volatility but are likely to move sideways on-trend. If, however, growth slows more rapidly than expected, commodity prices are likely to collapse – with energy prices leading the charge down.
  
  
• Because we had anticipated a sharp decline in crude, we have left our forecast for the price of crude relatively unchanged. The forward curve of crude has even fallen to levels that more closely reflect our own forecasts. The dollar-clearing arbitrage level continues to point towards support of crude at the $50-$55 per barrel range (Exhibit 1).
  
  
• Central banks all over the world have raised interest rates to stave off inflation (Exhibit 3).The problem is that higher interest rates engender slower growth. Our forecasts for 2007 show a broad-based slowing of growth and an easing of inflation. (Exhibit 4). This means that the policy rate moves of various central banks are expected to have had their desired impacts. But, it also means that growth will be slower in 2007 than it was in 2006. Since oil demand and global GDP growth are strongly correlated (Exhibit 5), it also means that oil demand is likely to slow.
  
  
• It is typical during the period of weak, or shoulder, demand in the fall that gasoline prices fall. It is, however, an absolute anomaly, however, how much they have fallen. The lack of a severe hurricane season has made the supply of refined products seem more secure, while the natural drop-off in gasoline demand has pushed down the demand-side of the equation. With wholesale gasoline prices close to $1.50 per gallon, we find retail gasoline prices also very close to their previous lows of the year back in February (Exhibit 6).
  
  
• Although prices have collapsed recently, the demand dynamics surrounding the plummet in prices is not perennial, but transitory. We expect gasoline demand will rise year-over-year, and that wholesale prices will rise with the on-set of refining ahead of the next peak driving season. Although it is difficult to call the bottom, given the weak gasoline demand dynamics in the winter, it is clear that retail gasoline prices are going to move towards $2.00 this winter, and perhaps be sub-two dollars in many areas. The concern about high gasoline prices and the move to more fuel efficient vehicles could see some diminution as prices ameliorate. Gasoline prices will not be enough to save the U.S. economy from this slowdown, and the impact to consumers is likely to be marginal. This is especially true since demand is up year-to-date by 0.7 percent. Still, we expect national retail gasoline prices to remain around the $2.00 to $2.25 level for most of the winter.
  
  
• While gasoline prices may hibernate for the winter before resurging sharply in the spring, heating oil prices have moved lower on a lack of demand that is soon to appear. The on-set of winter, or perhaps even the contract roll that will make the December heating oil contract the near-contract should begin to give this market some legs. Even if crude moves lower, heating oil is likely to move higher. Even if inventories are lush now, winter weather can be a real wild card. Sure, El Nino is poised to allow for a mild winter in the Northeast, but wasn’t the 2006 hurricane season supposed to be just as bad as the 2005 season with the potential for a Katrina-Rita redux? We’re not likely to put much stock in the forecast for an abnormal anything, but see the likelihood of an average winter to be more likely. As such, we believe that there are upside risks to heating oil prices from current levels. Furthermore, if the winter does turn out to be cold, we see the potential for higher prices in the spring, especially with competing distillate demand coming from the diesel space.
  
  
• Gasoline prices, heating oil prices and crude oil prices have plummeted. Only diesel prices haven’t fallen as far, or as fast (Exhibit 7). It’s clear that diesel prices are displaying stickiness on the downside, and it has everything to do with the conversion from low sulfur diesel to ultra low sulfur diesel that will be completed by January 1, 2007. This conversion process is no where near complete. Ultra low sulfur diesel inventories have been rising, but low sulfur diesel remains a significant portion of inventory (Exhibit 8). In other words, there are real concerns about diesel supply. So, even if heating oil and diesel prices have fallen, there is weather cyclicality to the price of heating oil and it is a distillate product, which means that there is a risk of a physical diesel shortage in some areas at the end of the year and through the beginning of 2007. The impact this will have on crude is less clear, but it is extremely likely that as ultra low sulfur diesel demand surges, and heating oil demand peaks, prices of distillate products could spike. Much will depend on the weather, but while retail gasoline moves towards $2.00 per gallon, retail diesel is likely to move towards $3.00 per gallon, with even further upside risk at the pump.
  
  
• OPEC production has been around 30 million barrels per day for a number of months. Recently, however, the amount produced has been sliding moderately for the past few months (Exhibit 9). This has been more the result of easing demand, rather than a concerted effort to cut off supplies. At the last OPEC meeting, a production cut was discussed, but no unanimity was reached. Even if there is a meeting, it is not likely to occur before the end of Ramadan on October 23rd. Furthermore, even if there were a production cut of one million barrels, it is likely that some members may cheat, of which there is a long tradition. Still, it could give some footing to the market as it heads into the stronger heating oil demand season. Oil prices may be down, but are likely not out. Mother Nature, however, could be a more important market mover than OPEC.
  
  
• For the past three weeks, natural gas injections have been below 80 Bcf. Although still decent builds, we have seen the surplus of inventory above the five-year moving average diminish to the lowest level all year – at 11.8 percent (Exhibit 10). Near-contract prices have moved up with the trading of the November contract and the on-set of somewhat colder weather. Rig counts remain high, but the contango in the winter strip -- with a peak near $8.00 – shows that risks remain to the upside beyond the shoulder period. Still, we have revised down our forecasts for natural gas prices for the coming year (Exhibit 11), demand may slacken with slower economic growth, and rig counts remain near record levels.

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Published on  Mon, Oct 16 2006, 07:08 GMT

Euro−zone Chartbook – Q4 2006

Wed, Oct 11 2006, 15:27 GMT
by Jason Schenker

Wells Fargo Investments, LLC

• Euro-zone growth in the second quarter was the strongest it has been since 2000 (Exhibit 1). At the same time, the European Central Bank (ECB) is extremely concerned about consumer inflation, which at 2.3 percent, is above the 2.0 percent ECB target level (Exhibit 2). With a backdrop of strong growth, the ECB has been a position to make monetary policy less accommodative by raising rates (Exhibit 3).
  
  
• We currently believe that the ECB is going to hike rates again before the end of the year. But, with the onset of a rise in the German VAT (value added tax), there are concerns about German consumption and the impact this could have on Euro-zone consumption as a whole. This means that the ECB is likely to slip into a more data dependent mode with the onset of 2007.
  
  
• We expect the VAT hike to have a slowing impact on growth and to engender some inflationary pressures (Exhibit 8). We also expect inflationary pressure coming from potentially higher cost of diesel at the beginning of the year, stemming from the U.S. conversion to European diesel, which has lower sulfur content.
  
  
• Euro-zone unemployment still remains high at 7.8 percent (Exhibit 4). Even though there has been some improvement in the unemployment rate in recent quarters, the retail space remains somewhat stagnant (Exhibit 5).
  
  
• In contrast to the retail sector, industrial production has improved in the Euro-zone, and remains a source of economic growth. (Exhibit 6). The higher cost of capital, however, is likely to engender some slowing in this space next year.
  
  
• With the onset of the Fed’s holding of rates at 5.25 percent, the euro has strengthened against the greenback (Exhibit 7). This strength could show volatility depending on market data, but we believe that the dollar is likely to weaken against the euro on trend.
  
  
• The ECB is likely to hike its main policy rate 25 basis points before the end of the year, while the Fed is likely on hold. For 2007, we see the ECB on hold and the Fed cutting the Fed Funds Rate by 25 basis points in the first quarter. As such, interest rates are likely to be fundamentally dollar-bearish, especially with the backdrop of an extremely wide U.S. current account deficit (Exhibit 8).

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Published on  Wed, Oct 11 2006, 15:27 GMT

North Korea's Nuclear Test

Tue, Oct 10 2006, 15:33 GMT
by Jay H. Bryson

Wells Fargo Investments, LLC

North Korea announced yesterday that it had successfully detonated a nuclear device. It is no secret that the country has been trying to develop a nuclear bomb, but the announcement of the successful test served to confirm the world’s worst fears.

That said, the fallout in financial markets has been rather muted. Predictably, financial markets in South Korea were affected the most. The South Korean won weakened 1-½% versus the dollar yesterday, a big daily move for that currency, and the South Korean stock market (measured by the KOSPI index) fell 2.4% yesterday, but it bounced back a bit today. However, financial markets in other countries in the region have taken the news in stride. The stock market in Japan, the country after South Korea that would be threatened the most, hardly reacted to the news, as did the Japanese yen.

There clearly are numerous geopolitical ramifications of a nuclear North Korea, which are beyond the scope of this short report. Barring the unthinkable (i.e., a North Korean nuclear strike on South Korea or Japan), which clearly would be devastating, the purely economic and financial implications seem to be rather limited. Yes, the Indian stock market fell 30% in the months after that country’s nuclear test in 1998, and the Pakistani stock market went down 50% Both the Indian and Pakistani currencies depreciated significantly in 1998. However, the financial and economic crises that swept through emerging markets in 1998 probably contributed to the weakness in financial markets in the subcontinent that year. Moreover, sanctions by the West had a direct impact on the Indian and Pakistani economies. Nobody is suggesting that sanctions be placed on South Korea.

The sanctions that are being contemplated against North Korea, which already has very little trade and financial interaction with the rest of the world, could weaken that economy further. In the (admittedly low probability) event of a North Korean collapse, the economic spillover on South Korea would be significant. As noted above, the economic and financial ties between the South and the North are rather limited at present. However, as we discuss in a recent report, the drain on the South Korean economy from economic and political reunification of North and South Korea (à la East and West Germany) would be significant.

Barring these worse-case scenarios (i.e., a nuclear strike or a collapse of North Korea), the purely economic and financial implications of North Korea’s announcement seem rather limited. Indeed, Moody’s announced that South Korea’s ratings are unlikely to be affected by the news from Pyongyang. That said, near-term growth prospects in South Korea could be affected somewhat if consumers and businesses turn more cautious.2 In addition, investors may perceive South Korean assets to be a bit more risky. The South Korean stock market, which has underperformed most other stock markets this year, could continue to struggle as foreign investors rethink their desire to hold South Korean equities.

The news has also led us to make some minor changes to our forecast for the Korean won (see Exhibit 1). Our previous forecast of won appreciation versus the greenback was based more on our projection of generalized dollar weakness than it was on anything intrinsic to South Korea. Therefore, we maintain our view of won appreciation versus the greenback on a trend basis. However, we now project that the won will strengthen less against the greenback than we did previously due to a higher risk premium on South Korean assets.

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Published on  Tue, Oct 10 2006, 15:33 GMT

Korea Chartbook

Tue, Oct 10 2006, 15:29 GMT
by Jay H. Bryson

Wells Fargo Investments, LLC

• Real GDP growth in South Korea has downshifted a tad thus far in 2006, but the year-over-year growth rate generally remains solid at more than 5% (Exhibit 1). The slowdown has been led by deceleration in domestic demand. Although retail sales growth on a nominal basis remains rather strong (Exhibit 2), the rise in inflation this year implies slower growth in the volume of retail spending.
  
  
• Real GDP growth likely will slow a bit over the next year or so. The decline in consumer confidence over the past few months suggests that growth in consumer spending could weaken somewhat further. Indeed, the consensus forecast reflects an expectation that real GDP growth will slow from about 5% this year to 4-½% in 2007. Net exports have contributed positively to Korean real GDP growth over the past few years. However, the trade surplus is not as large as it had been (Exhibit 3), and slower economic growth in the rest of the world should spill over to Korea via deceleration in exports.
  
  
• Strong economic growth last year and the modest rise in inflation this year (Exhibit 4) have prompted the Bank of Korea to tighten monetary policy over the past year (Exhibit 5). However, CPI inflation is currently at the lower end of the Bank’s target range of 2.5% to 3.5%. With growth slowing and inflation under control, most investors expect little, if any, further monetary tightening by the Bank of Korea.
  
  
• The Korean won has strengthened about 40% versus the dollar since late 2002 (Exhibit 6). Part of the strength of the won reflects generalized dollar depreciation over the period. Moreover, Korean authorities have showed more tolerance for currency appreciation than some of their counterparts in Asia. So far, nuclear saber rattling from North Korea does not seem to have had much impact on the Korean won.
  
  
• Barring a major confrontation between the United States and North Korea, we project that the Korean won will strengthen a bit further over the next year or so. (Exhibit 7). (See also “North Korea’s Nuclear Test”, which is posted at www.wachovia.com/economics.) This forecast is based on our expectation that the dollar will decline modestly going forward as Fed easing early next year causes interest rate differentials between the United States and the rest of the world to narrow.

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Published on  Tue, Oct 10 2006, 15:29 GMT

U.K. Forecast Chartbook – Q4 2006

Wed, Sep 27 2006, 16:03 GMT
by Jason Schenker

Wells Fargo Investments, LLC

• The Bank of England raised its main policy rate to 4.75 percent in August (Exhibit 7). We foresee one more rate hike from the MPC before the end of the year. Inflation remains above the Bank of England’s target range, and the retail sector has shown improvement. On the downside, however, unemployment has been rising, industrial production remains weak and global growth is slowing.
  
  
• Growth in 2006 is going to be stronger than it was in 2005, but is likely stronger than the growth rates we are anticipating for the U.K. in 2007. We expect a gradual softening of growth, but nothing anywhere near a collapse. Inflationary pressures have backed the Bank of England against a wall, since CPI inflation is currently above the Bank of England’s target of 2.0 percent (Exhibit 3). But, energy prices have shown some easing (Exhibit 2). The recent drop is primarily seasonal, but we see some easing in pressures from the energy space in the coming year, as slowing global growth allows 2007 oil prices to average closer to $60 per barrel, rather than the $65-plus average we are likely to see for 2006.
  
  
• Retail spending in the U.K. has improved sharply since the beginning of the year (Exhibit 5). Unemployment, however, could threaten further retail growth. With the unemployment rate now at 5.5 percent, it is at the highest level since May 2000 (Exhibit 6). Retail sales could weaken if unemployment rises further.
  
  
• Aside from the rise in unemployment is, a point of concern in the U.K. remains the sluggish industrial sector. Year-over-year rates of industrial production remain in negative territory, while manufacturing production rates are soft (Exhibit 10). If this sector remains weak, it could hamper growth moving forward and, coupled with rising unemployment, keep the BOE from hiking rates.
  
  
• Sterling has strengthened against the greenback since the beginning of the year (Exhibit 4). Further BOE policy moves to hike rates are likely to counter a Fed rate cut in Q1 2007. Coupled with the current account deficit, these interest rate differentials are likely to be fundamentally bearish for the greenback. Our forecast is for a gradual depreciation of the dollar against most major currencies, including the pound (Exhibit 1).

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Published on  Wed, Sep 27 2006, 16:03 GMT

U.K. Chartbook

Wed, Aug 2 2006, 12:16 GMT
by Jason Schenker

Wells Fargo Investments, LLC

• The Bank of England has continued to hold its main policy rate at 4.50 percent (Exhibit 7). The Bank’s next likely move would be to hike rates, but that does not appear to be imminent. Inflation is clearly above the Bank of England’s target range, and although the retail sector has shown some improvement, unemployment has been rising and industrial production remains weak.
• Growth seems poised to remain stronger in 2006 than last year, but growth is likely to slow next year (Exhibit 1). As a result of the recent run-up in crude and petroleum product prices in the U.S. and in Europe (Exhibit 2), inflationary pressures remain high through 2006.
• Aside from the inflationary risk, there are growth prospects to consider. While retail spending in the U.K. has improved since the beginning of 2006 (Exhibit 5), unemployment rates in the U.K. have been inching upward in recent months (Exhibit 6).
• Economic growth in the U.K. has improved in recent quarters. In the second quarter, quarter-over-quarter non-annualized growth was 0.8 percent (Exhibit 8), and was up 2.6 percent year-over-year (Exhibit 9). These rates represent significant improvements over rates from the second quarter last year.
• A big concern in the U.K. remains the sluggish industrial sectors. Year-over-year rates of industrial production remain in negative territory, while manufacturing production rates are stagnant at best (Exhibit 10). If these sectors continue to remain weak, it could hamper growth moving forward and, coupled with rising unemployment, keep the BOE from hiking rates.
• Sterling has struggled against the dollar since the beginning of the year (Exhibit 4), and we believe that the ever-widening U.S. current account deficit is likely to further weigh on the dollar. Our forecast is for a gradual depreciation of the dollar against most major currencies, including the pound (Exhibit 1).

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Published on  Wed, Aug 2 2006, 12:16 GMT

Euro−zone Chartbook

Mon, Jul 31 2006, 09:58 GMT
by Jason Schenker

Wells Fargo Investments, LLC

• The European Central Bank (ECB) is in the process of fighting inflation and tightening rates (Exhibit 3). Another 50-75 basis points worth of rate hikes are highly likely this year, and recent statements have led market participants to believe that an August rate hike is in the cards. Decent Euro-zone growth, coupled with above-target inflation has the progeny of the Bundesbank set on hiking more.
• Already sluggish retail spending growth in the Euro-zone has slowed further in recent months (Exhibit 5), while unemployment remains high (Exhibit 6). Although growth could continue to yield moderate improvements, the employment scene in Europe is not likely to change radically in the near-term.
• Largely as a result of high unemployment and weak domestic consumption, Euro-zone economic growth has remained anemic. In the first quarter, quarter-over-quarter non-annualized growth was 0.6 percent (Exhibit 7), and was up a solid 2.0 percent year-over-year (Exhibit 8). These rates are weak, but have manifested some slight strength over the past few quarters. In the near- to medium-term, indices like the IFO have been pointing towards growth. The rising cost of crude oil (Exhibit 2) and rising rates, however, are likely to weigh on growth next year (Exhibit 1).
• The trade deficit in the United States remains wide. In the Euro-zone, the trade balance is quite often positive – driven by strong exports (Exhibit 9). However, Euro-zone exports could decelerate if the U.S. should grow more slowly in coming quarters or dollar depreciation were to accelerate.
• The Euro-Dollar exchange rate has showed significant volatility over the past quarter (Exhibit 4). We believe that fundamentally dollar-bearish interest rate differentials are likely to weigh on the dollar in coming quarters (Exhibit 1). High volatility, however, is likely to remain as geopolitical concerns and questions about the Fed’s next moves have engendered significant uncertainty.

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Published on  Mon, Jul 31 2006, 04:58 GMT

German Mid−Year Economic Review

Fri, Jul 28 2006, 08:36 GMT
by Jason Schenker

Wells Fargo Investments, LLC

The German economy is in flux and the World Cup, as well as the mid-year, offers us an excellent opportunity to address some of the key economic issues and questions currently surrounding the German economic outlook. The German economy seems to have been gaining strength. However, there are some longer-term issues that pose continued structural issues for the German economy. These longer-term challenges are where our sights should be beyond the next eight quarters. The longer-term outlook for German growth is more dubious than near-term strength that may yet prove fleeting.

Highlights:

• The German economy has been strengthening. It is, however, a mixed bag at mid-year. Growth is supported by exports, manufacturing and capex. (Page 2)
• The retail sector remains soft in Germany, and although unemployment in Germany has been falling, it remains very high. (Page 4)
• With higher energy costs and rising interest rates, however, we see some slowing likely next year. In terms of the prospects of the country as a whole, we are cautiously optimistic about 2006.
• The disparity between economic conditions in the former East and West Germany persists. Unemployment in the so-called “new” Bundeslaender still poses a significant economic challenge to Germany as a whole. (Page 5)
• Austere monetary policy is going to be implemented by the European Central Bank (ECB). The progeny of the Bundesbank has a single mandate: to control inflation. As such, it is unlikely it will let inflation get too far beyond its reigns. (Page 6)
• Confidence indicators are sending mixed signals. (Page 7)
• The dollar has strengthened over the past year, but is poised to fall in coming quarters against the euro. (Page 8)

The Current State of the German Economy: Mixed Signals at Mid-Year

At the beginning of the year, there were a number of market participants that viewed the German economy optimistically. We have always viewed the German economy with a guarded optimism. With German GDP growth floating around 1.5 percent year-over-year, there is little reason to celebrate other than the recent World Cup events (Exhibit 1). Real German GDP has accelerated in recent quarters, but growth still remains rates that were posted in 2000. Furthermore, despite surges in German confidence series at the beginning of the year, the biggest threats to the German economy remained fully in place. These risks, remain weak domestic retail consumption and high unemployment.

Export Growth

The two legs supporting German economic growth have been exports and capex. Germany is well-known for its significant exports, which have risen in recent quarters (Exhibit 2) largely as a manifestation of strong global demand. This also means that if global growth slows over the next eight quarters, as we anticipate it will, the German economy could be more significantly exposed on the downside.

Capex Growth

In tandem with the rise in German domestic production of goods for export, has been a concomitant rise in capital expenditures. Over the past seven quarters, German capex has risen (Exhibit 3). Business investment in coming quarters is likely to continue to be critical for German growth, especially as higher energy costs, higher interest rates and a higher value added tax (VAT) rate threaten the purchasing power of German consumers.

German Consumers Still Snoozing

While the strength of the German economy has manifested itself in exports, manufacturing and capex, the retail sector looks dismal. German retail sales in May were essentially flat compared to the same month last year (Exhibit 4). That’s right: despite economic growth and a declining unemployment rate, Germans have barely increased their domestic retail consumption over last year. Like the U.S. and other G7 countries, Germany has long since transitioned to a service-based consumer economy. Despite this fact, consumers are not yet on the band wagon. Furthermore, the expected rise in the German VAT tax next year is not likely to help consumer spending either.

Unemployment Cripples German Consumers

Aside from a high savings rate stemming from a savings tradition and exacerbated by country-wide fears about the imminent collapse of the German social system, high levels of unemployment have not helped the retail sector. After all, with 10.9 percent unemployment, how can you blame German consumers for not spending their euros? High German unemployment rates are largely the result of high costs of labor and costs of labor termination, and although there has been a gradual diminution in unemployment since the beginning of 2005, German unemployment rates remain among the highest in the Euro-zone, and much higher than the Euro-zone average (Exhibit 5). The aberrational and sizable bump-up in the beginning of 2005 can be attributed to the new statistics implemented under Hartz IV employment legislation. This legislation was designed to encourage workers to find employment, even if it should be at a lesser level of qualification or rate of pay than their previous employ. There have been objections to the pressures Hartz IV places on discouraged workers, but it is also likely responsible for the reduction of the number of workers on the dole.

Germany Still Divided

An even more pronounced cause for employment concern is the repercussion the division of Germany has had on the disparity of employment. The former East German states continue to experience much worse unemployment than their former West German counterparts (Exhibit 6).

Implications of Unemployment

The high rate of German unemployment continues to pose a significant secular challenge to German economic growth in both the near- and medium-term. The aging German population has also taken the threat of German social security collapse quite seriously, and this has further hampered consumers focused on the potential impact on their incomes. At the same time these longer-term issues are likely to keep consumer expenditures weak, rising interest rates and high energy prices are likely to further assault whatever consumer inclination to spend may remain.

Inflation and the European Central Bank

Inflationary pressures in the Euro-zone and Germany have been rising, and the European Central Bank (ECB) has been raising rates as a counter measure. The ECB, which is largely the progeny of the Bundesbank (BuBa), has a single mandate: to control inflation. This most critical single mandate of the BuBa was largely implemented as a result of the German experience with hyperinflation in the 1920’s.

The ECB has a stated inflation target of two percent. The current level of inflation is around 2.5 percent (Exhibit 7). With inflation on the rise, BuBa vigilance has driven the ECB to hike rates twice this year, and is likely to drive the ECB to further rate hikes in coming months. Based on ECB members’ statements, the markets already assume a hike at the next meeting on August 3rd to be a de facto reality.

High ZEW Confidence Early in the Year

The German ZEW is a measure of the expectations of future economic growth in Germany over the next six months based on the survey responses of about 350 different institutional investors and analysts. The ZEW was at record levels at the beginning of the year (Exhibit 8), which provided some analysts with the statistical fodder to forecast strong GDP growth this year. The index, however, has since tumbled, which means that if analysts and investors are correct, a significant slowing in growth in the second half of the year is likely.

IFO Index Recently Pulled Back

The IFO index, which is more strongly correlated with German GDP growth than the ZEW index was also on the uptake at the beginning of the year, and is now even higher despite a pull-back in June. The extremely mixed signal the IFO is sending is somewhat odd. Like the ZEW, the IFO also provides a reading of how the economy will perform over the next six months, but is based on survey responses from approximately 7000 companies. So, companies are a bit more optimistic, while investors and analysts seem skittish. This sounds familiar to Americans, who have seen a choppy summer for equities and mixed signals from the Fed. Furthermore, while U.S. consumers are likely to reduce their spending, business investment is likely to support growth. In Germany, this also appears to be the case.

The Euro and the Dollar

We believe that the euro, like most major currencies, is likely to appreciate against the greenback in coming quarters. Fed rate hikes over the past year provided fundamentally dollar-bullish interest rate differentials (Exhibit 9) , but with the Fed nearing the end of its interest rate hiking cycle, and the ECB (as well as other central banks) ramping up their hiking cycle, the tide seems poised to turn against the dollar. The massive expansion of the U.S. current account deficit is also likely to provide a further weight on the back of a dollar being pushed to weakness by fundamental interest rate differentials. As such, we are forecasting a mild and gradual depreciation of the dollar against the euro in coming quarters (Exhibit 10).

• Download full German Mid-Year Economic Review

Published on  Fri, Jul 28 2006, 03:36 GMT

Inflation Chartbook

Tue, Jul 25 2006, 07:51 GMT
by Mark Vitner

Wells Fargo Investments, LLC

Worries that inflation will accelerate to a pace bond investors and policymakers find unacceptable have taken hold in recent months, fanning fears that the Federal Reserve will be forced to raise interest rates more than most forecasters had expected. Concern about inflation has been curbed a bit recently, however, as the Fed Chairman Ben Bernanke and a whole host of Federal Reserve governors and regional bank presidents have made it clear that the Fed was not about to let inflation or inflationary expectations rise to unacceptable levels. Just what those levels are is subject to a bit of debate. Nearly every measure of inflation has accelerated during the first half of 2006. The Consumer Price Index (CPI) is currently up 4.3 percent on a year-to-year basis, compared to gains of 3.4 percent in 2005 and 3.3 percent in 2004. Core inflationary pressures have also intensified. Prices, excluding food and energy items, are currently up 2.6 percent from their year ago level compared with year-end readings of 2.2 percent in both 2005 and 2004.

Price increases have also intensified a few steps back in the production process. The Producer Price Index (PPI) for finished goods has increased 4.9 percent over the past year, which is actually down a bit from the 5.4 percent year-to-year gain posted at the end of 2005. Finished goods prices rose 4.2 percent in 2004. Excluding food and energy prices, finished goods prices have been relatively well behaved, rising 1.9 percent over the past year, compared to a 1.4 percent gain between December 2004 and December 2005.

Looking a little further back in the production process, prices for intermediate materials, supplies and components are up 9.3 percent over the past year. Excluding food and energy items, core intermediate goods prices have increased 9.6 percent. Prices for raw materials have increased even more dramatically, with prices for crude materials rising 8.6% and prices for crude materials, excluding food and energy items, leaping 33.7 percent.

Import prices are not directly factored into the PPI, although the competition from imports does impact the ability of domestic producers to increase prices. Moreover, the stronger demand for raw materials from emerging economies is helping drive up the prices of raw materials. Overall import prices are currently running 7.2 percent above their year ago level. Most of that increase is due to soaring oil prices. Excluding petroleum, import prices are up 2.2 percent over the past year.

The last inflation measure that we will highlight is the one that the Federal Reserve cites most often as their preferred inflation gauge. The price deflator for Personal Consumption Expenditures (PCE) is published by the Bureau of Economic Analysis along with data on personal income and spending. The PCE price deflator utilizes a great deal of the price data from the Consumer Price Index. The PCE price data, however, are “chain-weighted” so that they reflect consumers changing consumption patterns. If prices of beef rise dramatically and consumers buy more chicken, then chicken prices will get a higher weight and beef prices will get a lower weight. The CPI is based on a fixed-weighted market basket of goods and services.

The Federal Reserve prefers to utilize the core PCE price deflator, which excludes food and energy items. The exclusion of food and energy items is done for two reasons. Food and energy prices are extremely volatile and make it more difficult to discern the underlying trend in inflation. In addition, there is little that monetary policy can do to directly influence food and energy prices. If there is a drought in the Midwest that forces up grain prices, the Fed can not make it rain. Similarly, the Fed has little sway over OPEC or even U.S. energy policy. By contrast, price increases for virtually everything else are influenced by monetary policy. The core PCE deflator best represents the part of inflation the Fed can do something about.

Wachovia’s Inflation Chartbook will periodically take a look at the key inflation measures and their major components. We will also identify the factors we believe will shape the near-term inflation outlook and our forecast for inflation and interest rates.

The Consumer Price Index

Any discussion about inflation invariably starts with the Consumer Price Index, which is the most often cited measure of inflation. The CPI has accelerated considerably over the past four years and is currently up 4.3 percent over the past year. Excluding food and energy prices, the core CPI is up somewhat less, climbing 2.6 percent over the past year.

Most of the acceleration in the overall CPI has come from higher energy costs. Energy items account for just 8.7 percent of the overall CPI, with motor fuels and household fuels accounting for roughly even proportions of that total. Prices for motor fuels have surged in recent years, soaring 26.1 percent in 2004 and climbing another 16.2 percent in 2005. Gasoline prices soared again this year, rocketing up at nearly a 52 percent annual rate over the past six months. Fortunately, prices for household fuels have risen more modestly. The cost of fuel oil has increased at a 9.6 percent annual rate over the past six months, while prices for residential natural gas have fallen at a 15.5 percent pace.

Food and beverages account for 15.05 percent of the overall CPI and have been relatively well behaved in recent years. Food prices rose just 2.3 percent in 2005, which was slightly less than the 2.7 percent gain the prior year. Grocery store prices account for just over half of the total weight of food and beverages and prices there have been fairly well behaved, climbing just 1.7 percent last year and 2.4 percent in 2004. Prices have risen even less rapidly this year, inching up at just a 1.2 percent annual rate over the past six months. Prices for food eaten away from home (restaurants) have picked up a bit, however, climbing at a 3.6 percent annual rate over the past six months. The cost of dining out rose 3.2 percent in 2005 and 3.0 percent the prior year. The higher costs this year likely reflect rising wage and salary costs.

• Download full Inflation Chartbook report

Published on  Tue, Jul 25 2006, 02:51 GMT

The Bernanke Era Begins

Wed, Jun 28 2006, 17:08 GMT
by Mark Vitner

Wells Fargo Investments, LLC

The financial markets and policymakers will get their first hard look at Ben Bernanke in his new role as chairman of the Federal Reserve Board when he delivers the Federal Reserve’s semi-annual monetary report to Congress on Wednesday. The general perception is that Bernanke’s view of the economy will be remarkably close to that of Alan Greenspan and that monetary policy will likely remain on its present course. While we agree with that near-term assessment, Bernanke will be different from Greenspan and we would not surprised if some of the differences surface in his initial testimony before the Congress.

The general perception is that Bernanke’s view of the economy will be remarkably close to that of Alan Greenspan.

Looking back at Alan Greenspan’s tenure at the Fed, one of the most notable things that surfaced was how he systematically went about removing some of the unnecessary mystique that had long existed at the Fed. Not only did the Fed’s moves become more transparent but the justification for its actions and the concerns of the FOMC and Fed Chairman himself were made public. Suddenly the financial markets became transfixed with whatever the Chairman was watching.

The Fed’s economic forecast was developed before Bernanke was sworn in.

One of the first indicators that caught Greenspan’s eye was the ISM report. Later the Fed Chairman showed an affinity for scrap steel prices and the core intermediate goods component of the Producer Price Index. When the unemployment rate hit 5.5% back in the mid 1990s, Greenspan brought up the issue of the Pool of Available workers to question just how close to the economy’s resource constraints the economy actually was. Later, when the apparent tightening of resource constraints had failed to trigger a run-up in inflation, Greenspan began to question the validity of the productivity measures and divulged that his favorite was the nonfinancial corporate productivity series.

Bernanke’s prepared remarks are not likely to reveal much about how the conduct of monetary policy will differ from that of Greenspan’s leadership. The Fed’s forecast was developed before Bernanke was sworn in. The language will probably be similar to what has been reported in the minutes of the last three FOMC meetings. One thing that has figured prominently in those minutes is the Fed’s growing concern about further increases in the economy’s rate of resource utilization and their resulting pressure on prices. If Bernanke does not address this in his testimony, he most certainly will be asked about it in the much longer question and answer period that will immediately follow.

One of the critical questions for Ben Bernanke to answer this week will be what measures of resource utilization will the Fed look to under his leadership to determine if the economy is bumping up against its long-term growth constraints.

With resource constraints once again on the Fed’s short list of concerns, one of the critical questions for Ben Bernanke to answer this week will be what measures of resource utilization will the Fed look to under his leadership to determine if the economy is bumping up against its long-term growth constraints? Specifically, will he focus on labor market indicators, such as the unemployment rate, pool of available workers and compensation costs or does he favor some sort of output gap measure? How he answers these questions will go a long way toward informing the financial markets what data to scrutinize in coming months.

For many policymakers most labor market indicators are already at uncomfortably low levels. The unemployment rate has recently fallen to 4.7%, its lowest level since July 2001. By comparison, the average unemployment rate for the past 40 years has been 6%. Other measures of labor market strength are also flashing warning signs. First time claims for unemployment insurance have averaged less than 300,000 per week for four weeks in a row, marking the lowest level for unemployment claims since April 2000.

Average Hourly Earnings have risen 3.3% over the past year and are running well ahead of their four-year average.

While low unemployment is clearly preferable to high unemployment, policymakers begin to worry if the unemployment rate falls too low because that might force labor costs up and send inflation higher. For the more hawkish members of the FOMC, the fear about rising labor costs has been a growing concern and is one of the reasons why the recent policy statements have alluded to “possible increases in resource utilization” having “the potential to add to inflation pressures.”

The potential for rising inflation clearly is there. Average hourly earnings, which are reported along with the nonfarm jobs and unemployment rate, have risen 3.3% over the past year and are now running well ahead of their average for the past four years. Just what this means, however, is a contentious point. The last time average hourly earnings broke through their four-year moving average was right after the Fed finished its first round of tightening back in the mid 1990s. Back then, the Fed correctly anticipated that the rapid growth in information technologies and globalization would limit the ability of firms to pass their higher labor costs to final consumers. This still appears to be true today.

The Employment Cost Index shows wage and benefit costs rising only modestly.

Hourly earnings are not widely thought to be the Fed’s preferred measure of labor costs and other measures, specifically the Employment Costs Index and Unit Labor Costs, show labor costs to be much more restrained. Not only have wages and salaries risen by a much more restrained 2.6% over the past year, but benefit costs have also tumbled as companies have struggled to contain health care costs and restructure pension plans.

The pressure on businesses to rein in benefit costs is a direct result of growing global competition, which has made it much more difficult for businesses to pass along their higher costs to their end-consumers. As a result, businesses have been striving to boost productivity and slash costs. While there have been successes on both scores, the impact on workers in the airline industry, automotive sector and even big multi-nationals like IBM has been significant.

Another area where resource utilization has been increasing has been the factory sector, where the capacity utilization rate has risen 0.9 percentage points over the past year to 80.7%. That puts the capacity utilization rate just slightly under the average for the past 39 years and is still slightly below levels that have historically led to shortages, bottlenecks and higher prices.

Capacity utilization rate has risen 0.9 percentage points over the past year to 80.7%, which is just below its long-run average.

Energy, particularly gasoline and natural gas, is another resource constraint the economy is currently bumping up against. Federal Reserve Bank of Cleveland President Sandra Pianalto commented on this today noting that “energy-market disruptions, a supply condition, could go a long way toward explaining why economic activity, including consumer spending, was more restrained than in the recent past.”1 We would expect Ben Bernanke to receive some questions as to how the Fed should react to rising energy costs and why they have not been passed on into prices of other goods and services as much as they were back in the late 1970s.

One of the more interesting things to watch is whether or not he will be able to successfully steer clear of discussions on fiscal policy and other issues not related to the Fed’s mission.

There will also likely be several questions about what the Fed’s informal inflation target is and whether or not the Fed should establish a formal target. The current informal target rate is for the core Personal Consumption Expenditures price deflator to rise somewhere between 1% and 2%. The core PCE deflator is currently near the top end of that range. What does the Fed plan to do about this? How much growth is it willing to sacrifice in order to keep the core rate of inflation at or below 2%? Remember, the Fed has a dual mandate to maintain price stability and pursue maximum sustainable economic growth. Most Fed Governors and Federal Reserve Bank presidents would prefer to pursue the former, while politicians are typically much more concerned with the latter.

Bernanke will likely be asked about several other issues and one of the more interesting things to watch is whether or not he will be able to successfully steer clear of discussions on fiscal policy and other issues not related to the Fed’s mission. This may be hard to do in today’s extremely partisan political environment. One issue that is certain to come up is the impact that the growing federal budget deficit is having on the economy and the recent inversion of the yield curve. Congress will likely ask if Bernanke is concerned about the inversion of the yield curve and whether or not it should be viewed as a warning sign for the economy and the Fed.

The financial markets will be watching closely to see if Bernanke’s assessment of the housing market differs from Greenspan’s earlier one.

Bernanke was one of the first Fed governors to bring up the concept of a global savings glut as a potential explanation as to why long-term interest rates have remained so low at a time of strong economic growth and growing federal budget deficits. We expect Congress to push Bernanke on this point and to pursue any thoughts he might have on whether foreign investors and central bank’s appetite for dollar-denominated securities might be waning.

Low long-term interest rates have been very important in sustaining the housing market. With existing homes slowing in recent months, Bernanke will likely be reminded how the Fed continued to tighten after the stock market bubble burst, which contributed to the recession. Several members may ask if the Fed is on this road again. Alan Greenspan tended to downplay fears of a housing bubble, often noting that while there was considerable froth in parts of the housing market there was no national housing bubble.

The Federal Reserve most likely has just two more quarter-point rate hikes ahead.

The financial markets will be watching closely to see if Bernanke’s assessment of the housing market is different from Greenspan’s earlier one. After all, the Fed’s 14 rate hikes already put in place have significantly curtailed much of the speculative activity taking place in the housing market and will soon cause mortgage payments to rise sharply for many folks with adjustable rate mortgages. Does the Fed want to slow the housing market or kill it?

Summary & Conclusions Ben Bernanke will make his first appearance before Congress as chairman of the Federal Reserve this Wednesday in front of the House of Representatives and Thursday in front of the Senate. He is widely expected to give a fairly upbeat assessment of the U.S. economy. After all, the economy is fairly close to nirvana right now, with the unemployment rate at a four and a half year low of 4.7%, the core rate of inflation just under 2%, real GDP growing just over 3%, and long-term interest rates under 5%. The critical questions for Bernanke will mostly deal with what he plans to do to keep the good times rolling?

The tricky thing for policymakers is that monetary policy works with a long and variable lag. Bernanke will have to anticipate what the economy is likely to do over the next two years if the Fed does what the financial markets currently expect the Fed to do, raising the federal funds rate another 50 basis points. He also needs to weigh the likely outcome of raising the federal funds rate more than that or less than that.

The current expansion has primarily been driven by consumer spending and housing.

One of the things that Alan Greenspan was fond of saying back in the 1990s is that when it came down to making a difficult decision he would choose the policy that would do the least harm to the economy if in hindsight that decision turned out to be the wrong choice. During the latter part of the 1990s that choice was to pursue a slightly easier monetary policy, as the forces of globalization and technological innovation helped contain inflation. More recently, however, the Fed has voiced concerns about supply constraints, which could be a clue these forces are not as powerful inflation fighting tools as they were a decade earlier.

The current expansion has primarily been driven by consumer spending and residential construction. Business investment, which adds to the economy’s ability to produce more goods and provide more services, has generally been lagging. The net result is that we are bumping up against supply constraints, most notably in the energy market, but also in the transportation sector and in the production of many key commodity-type products. Even with investment ramping up, it will take time before new capacity can be generated. With inflation near the top of the Fed’s comfort zone, we expect Bernanke to earn his inflation-fighting credentials early and to take a generally hawkish tone at his first semi-annual monetary policy testimony.

We currently expect the Fed to raise interest rates two more times, with one quarter point hike at the March 27/28 FOMC meeting and another occurring at the May 10 meeting. This would bring the federal funds rate target up to 5%. After that, we expect GDP growth to slow to a pace just below the economy’s long-run potential growth rate, a perfect landing. More modest growth should hold the unemployment rate essentially steady and help contain, and possibly even reverse, some of the incipient inflationary pressures that have cropped up in recent months.

While overall growth is expected to slow this year, business investment is expected to grow at about the same rate that it did last year, and possibly even a bit stronger than that. Increased business investment will ultimately boost the economy’s ability to grow and may make it possible for the Fed to pursue an easier monetary policy later in this business cycle. For the time being, however, we feel the risk to interest rates remains to the upside.

• The Bernanke Era Begins

Published on  Wed, Jun 28 2006, 12:08 GMT