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Friday Notes

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Stagflation fears take center stage again!

Fri, Jul 18 2008, 12:51 GMT
by HVB Group Global Markets Research

UniCredit Group

• Concerns. The nascent hope of a relaxation of the credit crisis and the end of the global economic downturn has been dashed. The renewed escalation of the US credit crisis combined with warnings of growing inflation risks as well as the bad macroeconomic figures have once again fueled stagflation fears among investors.
  
  
• Fannie & Freddie. It was only the Fed's and the Treasury's intervention that averted a collapse of the two mortgage giants. But the two institutions still have to be restructured meaningfully. That will aggravate the problems to obtain cheap and timely mortgage financing. The headwind for the economy is, therefore, picking up once again (pages 7-9).
  
  
• Growth. The production side already shows an US economy still teetering on the brink of recession (cf. chart). For the time being, the tax rebate checks and strong growth in net exports will continue to ensure solid growth numbers. But by this fall, the underlying weakness of the US economy will be evident also in the GDP figures (pages 4-6).
  
  
• Inflation. The Fed is, however, becoming increasingly concerned about rising inflation risks. Bernanke’s warnings of second-round effects due to high commodity prices are a clear hint. The renewed escalation of the credit crisis and the persisting growth weakness, however, prevent the normalization of monetary policy – but only until this December.
  
  
• Further topics:
  
   – Weekly Comment: Bernanke – dovish or hawkish? (page 2).
   – Germany: Export world champion takes a beating (page 10).
   – France: Dark clouds on the economic horizon (page 12).
   – Data outlook: Business climate and consumer confidence to deteriorate around the globe (page 14).
   – Market outlook: EUR and govies well supported (page 23).
  
  

Bernanke – Dovish or hawkish?

Bernanke painted a cautious and concerned picture in his testimony to Congress this week, emphasizing both persistent downside risks to growth and rising risks to inflation. The statement could sound dovish or hawkish depending on whether one focuses on Bernanke’s assessment of growth or of inflation. The growth outlook sounded less sanguine than at the last FOMC meeting, and it had to, given the recent decline in equity prices and the concerns about Fannie and Freddie. But Bernanke was markedly more hawkish in his assessment of inflation risks, with an explicit warning of the risk of second round effects. Some of the language invited comparisons with the ECB, but one needs to be careful here: the Fed does not have only “one needle in its compass”, and needs to weigh more carefully growth and inflation risks. Commodity prices played a central role: Bernanke’s baseline view is that fundamentals remain the main driver of oil prices. If he is right, his Testimony must have revealed much weaker US and global growth fundamentals, because oil prices dropped USD 9 per barrel as he spoke. At the same time, however, he conceded in a more explicit way than previously that the weaker dollar could have played some role. On balance, I see this week's testimony as consistent with a December rate hike, provided the growth outlook does not deteriorate significantly again.

 Commodities occupied a prominent place in the testimony. As already mentioned, Bernanke supported the view that fundamentals are by far the main driver of oil prices. He noted that the last several years have seen record world growth, concentrated particularly in emerging economies where growth is more energy-intensive and consumption often subsidized. On the supply side, he noted that production has risen only slightly, reflecting inadequate investment and geopolitical volatility. However, he recognized more explicitly than in the past that “… the decline in the foreign exchange value of the dollar has also contributed somewhat to the increase in oil prices”, although he argued that while difficult to quantify, this effect was likely to be of secondary importance. He also noted that some governments had tightened control over oil resources, restraining foreign investment and thereby preventing increases in capacity and production. Overall, the argument was in line with the position taken so far by the US Administration, which has underscored the importance of fundamental factors and pointed to the need that producers step up efforts to increase production in both the short and the long run.

 Bernanke also all but dismissed the role of financial speculation in boosting oil prices, noting that if financial speculation were boosting oil prices above the level dictated by supply and demand, one would expect to see a build-up of inventories, whereas inventories have declined over the last year. At the same time, both in the statement and in the Q&A Bernanke conceded that “steps could be taken to improve the transparency and functioning of futures markets” and that various measures were being considered, including changing the margins applied for futures trading.

 If the Fed is really convinced that oil prices are mostly driven by fundamentals, the idea of greater transparency in futures markets might be just a bone thrown to the politicians. However, the statement showed a degree of uncertainty in the Fed’s view on oil prices, in my opinion. Referring to the June FOMC meeting, Bernanke said that monetary policy makers expected global growth to slow over the next couple of years, cooling commodity prices and therefore inflation. At the same time, however, “in view of the persistent escalation of commodity prices in recent quarters, FOMC participants viewed the inflation outlook as unusually uncertain and cited the possibility that commodity prices will continue to rise as an important risk to the inflation forecast.” This seems to betray a concern that commodity prices might continue to rise regardless of global economic growth and therefore of supply and demand developments.

 As already mentioned, Bernanke was markedly more hawkish in his assessment of inflation risks, in my view, warning explicitly of the risk that sustained pressures from commodity prices might eventually trigger a wage-price spiral. He pointed to longer-term inflation expectations as a key indicator to watch in this respect, albeit acknowledging that they remain “reasonably well anchored” so far. The level of alert was not as high as in the ECB’s recent statements, and Bernanke reiterated that the pass-through of commodities into core prices has been limited so far. But it was a very clear recognition of the danger that rising commodity prices might eventually destabilize inflation expectations and result in second round effects. Compared to previous Fed rhetoric, This week's statement appears to place less faith in the idea that cooling growth in a flexible economy would suffice to keep second round effects at bay if commodity prices keep on rising.

 Bernanke clearly emphasized downside risks to growth, and here the housing market remains the main source of uncertainty and vulnerability. In this regard, Bernanke stressed the importance of guaranteeing that the Government Sponsored Entities (GSEs) Fannie and Freddie continue to support the mortgage market (cf. Research Note by Roger Kubarych). He expressed appreciation for the latest measures adopted in support of the GSEs, and suggested to Congress that further measures to support the economy should continue to focus on the housing market. He thought that more time was needed to assess the possible need for a second fiscal package.

Bernanke’s growth assessment this week sounded somewhat less sanguine, as the brief description given after the last FOMC meeting was put into a fuller perspective. This week, as in June, he stated that the economy continues to expand –i.e. no recession at least so far. However, against a more detailed discussion of the headwinds faced by household consumption and by investment, the observation that consumption and growth have held up better than expected so far loses much of its power. Bernanke also did not repeat the June FOMC’s sentence that downside risks to growth appear to have diminished – something that might have struck a hubristic note with Congress against the sharp drop in equity indices and the concern about the GSEs. Caught between a rock and a hard place, the Fed will anxiously monitor both activity and inflation data in the coming months, hoping no doubt for commodity prices to finally take their cue from worsened fundamentals. The recent fall in commodity prices seems to underpin this view. Should economic growth remain stable at current sub-par levels, it is my view that the Fed will be looking to start some normalization in interest rates by year-end. The reiterated concern about a weaker dollar and its, however uncertain, link with oil prices is a further argument in this direction.

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Published on  Fri, Jul 18 2008, 13:00 GMT