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Friday Notes

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The drag on the real economy is enormous

Fri, Nov 21 2008, 13:42 GMT
by HVB Group Global Markets Research

UniCredit Group

• Contagion. What began as a US housing crisis and dragged the global financial sector into the abyss is increasingly wreaking havoc on the real economy. The industrialized countries are sliding ever deeper into recession. The first (unrelated) victim is the auto industry. The big three US automakers are on the verge of collapse (pages 4-7 & chart below).

• Crisis. Sales of the "Detroit Three" are plummeting, unwanted inventories soaring, and losses piling up. Their plight is, however, more the result of a misguided product policy, inefficient structures and costly wage agreements than an offshoot of the financial crisis. Without government aid, bankruptcy is inevitable. When aid will materialize is uncertain, and whether it can stop the bleeding remains more than questionable.

• Spreading. The meltdown in the auto industry spilled over to Europe more quickly than the financial crisis. The primary victims are the subsidiaries of US groups (like Opel). But even European automakers have to scale back production or even close plants. And the (auto related) chemical industry is already reporting plummeting sales (domino effect).

• Brake. The drag on the real economy is enormous. The gross valueadded of the German auto industry (including retail & service) is 12%! The industry also plays a central role in other industrialized & emerging countries. The risks of a global recession are, therefore, rising steadily.

• Further topics:
  
  – Weekly Comment: Full circle (page 2).
  – Fed hints at further rate cut (page 8).
  – Italy. Lending growth on its way down (page 10).
  – Date outlook: Business climate throughout EMU continues to slump; US consumption expenditures plummet (page 12).
  – Market outlook: Govies in demand, EUR under pressure (p. 22).
  

Full circle

ECB President Trichet delivered a very thoughtful and interesting speech this week in London, laying out very clearly how the ECB approaches the complex challenges and tradeoffs posed by the current crisis. The speech is especially significant as the ECB has been facing sharp criticism from many observers for being behind the curve in its monetary policy response to the credit crisis impact on the real economy. Trichet outlined the arguments for a measured policy response, including the importance of safeguarding antiinflation credibility – a point that was also highlighted in the Bank of England’s recently released minutes. But it was in the Q&A that he made the most vivid and effective case, when he was asked about the risk of deflation. He noted that we seem to have come full circle, and it was exactly the fear of deflation that guided the previous excessively long monetary easing. As Trichet put it, not that long ago we were also worrying about deflation, not realizing that we were instead fuelling a dangerous asset price bubble. We still believe that the current downturn is dramatic enough to warrant a more aggressive policy response, to be reversed equally quickly once the economy recovers and inflation revives. This is the attitude that the Fed signaled earlier in the crisis, but it is still unclear whether the ECB is ready to adopt it. ECB Board member Bini Smaghi recently argued that it would not fit the less elastic structure of the eurozone, but Mr. Weber on Thursday seemed to espouse the Fed’s view. In any event, Trichet’s point that the current crisis itself should remind us of the value of a measured and pondered policy response cannot be easily dismissed. Bottom line: we still expect a 50 bp cut next month and maintain a 2.0% target for the refi rate – although after the surprise 100 bp rate cut by the Swiss National Bank on Thursday we see increased risks that the ECB might move by 75 bp.

Trichet’s speech started by placing the ECB’s policy strategy in the context of the theoretical and empirical economic literature, which has shown that monetary policy works best not through policy surprises, but through a transparent communication of both the objectives and the framework and strategy used to pursue them. Trichet noted that several studies have proved that inflation targeting leads to greater stability in inflation expectations, which become less responsive to macroeconomic shocks. In the eurozone, consensus expectations for long-term inflation have been stable in the 1.7%-2.0% range since the launch of the single currency in 1999, a powerful testimony to the anchoring effect of a numerical inflation target combined with a credible policy implementation.

In this context, Trichet noted that market-based measures of inflation expectations deviated temporarily from target last summer, reflecting the commodity price shock, but where then brought back under control – implicitly arguing that the July rate hike was both necessary and effective in preventing an un-mooring of inflation expectations with attendant second round effect. Trichet emphasized that clear communication is essential to help markets and economic agents at large distinguish between transitory shocks to prices and actual changes in the policy stance, thereby reducing the need for more drastic and brutal changes in policy that were instead needed in the past to correct “misconceptions” leading to unjustified shifts in inflation expectations.

In this regard, Trichet highlighted the role played by the ECB’s monthly press conference which, he argued, is even better than publishing the minutes, as it is more timely and gives the press the opportunity to ask questions to clarify the central bank’s thinking. He noted that, while the market impact of the ECB’s monetary policy meetings has diminished as the bank has become very predictable on a one-month horizon, the remaining impact comes from the press conference and not from the decision itself. A “reductive” interpretation of this would of course be that this is simply the ECB’s ability to clearly pre-announce its moves from month to month without actually pre-committing, but the main implication is indeed that the monthly press conference has often a very strong informational content, helping the market understand the ECB’s assessment of the economic and financial environment and its intentions. Always on the comparison between the press conference and the minutes which are published by other central banks, Trichet argued that there is a simple institutional reason why the ECB prefers not to disclose the votes of the individual Council members: the risk that the decisions of the Governors of national central banks might be seen as taken on a national perspective, reflecting national concerns and priorities, whereas all Council members think and vote on a eurozone-wide perspective. In other words, disclosing individual votes might undermine the perception of the ECB as a truly eurozone institution.

But it is in times of heightened uncertainty like the current one that communication is most important. And here, Trichet argued, the ECB’s approach is two-pronged:

– First, swift and decisive action on money markets to ensure that the monetary policy transmission channel remains effective;

– Second, a measured approach to reassessing the monetary policy stance with an eye to the medium term.

Meanwhile, the inflation target itself plays a key signaling role: comparing the ECB’s inflation forecasts with the target gives a good indication of how policy rates are going to move. In other words, Trichet emphasized the distinction between liquidity interventions and monetary policy, a distinction which has become a central tenet of its crisis response philosophy, and he stressed that the monetary policy response must be measured, with an eye to meeting its medium- term objectives. This is a controversial point. The underlying rationale for measured action would seem to be that as economic trends tend to move relatively gradually and in a context of uncertainty and delayed availability of data, monetary policy should be adjusted gradually over time to reach its medium-term goals. This should avoid the risk that, over-reacting to changing macroeconomic data, monetary policy might become too volatile and hence inject unnecessary volatility in the real economy. The rapid and sharp deterioration of macro data in the last couple of months, however, indicates that shifts in the real economy can be very swift rather than gradual. Given the lags in the impact of monetary policy decisions, this would in our view argue for a decisive, rather than measured, policy response. This indeed is the approach taken by the Bank of England: the minutes of the BoE’s last meeting, which took place on the same day as the ECB’s, state that “… the Committee should be prepared to react decisively in these circumstances.”, that is faced with a sharp decline in growth and in inflation projections, against the background of the worst banking crisis in a century. In the event, the BoE cut rates by 150 bp compared to the ECB’s 50 bp.

The BoE’s minutes also stress the importance of preserving the credibility of the inflation target: the Monetary Policy Committee thought that, while a cut of possibly more than 200 bp would be needed to meet the medium-term inflation target, cutting rates so sharply all at once might raise doubts as to the MPC’s commitment to medium-term price stability. Delaying part of the necessary easing would allow the MPC to gauge the market’s reaction to what was anyway an unexpectedly decisive action, to explain its change of view on the inflation outlook with the Inflation Report, to monitor developments in fiscal policy as well as in credit markets, and to support confidence with further cuts should the economy weaken more.

Is the ECB decisive enough at this juncture? Assuming our forecast of another 50 bp cut in December is accurate, we will have seen a reduction in the policy rate by 150 bp in two months, with more likely to come early next year. This is certainly decisive by the standards of the ECB’s history, but there is no doubt that it is less aggressive than the Fed’s and BoE’s policy stance. The ECB’s performance is also tarnished by the July rate hike, although we do realize that at the time the ECB had a very difficult judgment call to make. Logic suggested that the oil price was experiencing a bubble, but as in most bubbles, one after the other most analysts and market players capitulated, and acting on the assumption that it was a bubble required more and more faith. The ECB had to decide whether to take the risk that inflation expectations might eventually become unmoored by the apparently relentless rise in oil, and the risk that monetary tightening would further damage an already precarious growth outlook.

I still disagree with their choice at the time, but I do realize it was not a trivial one, from their perspective.

More rate cuts are certainly on the way, from both the BoE and the ECB. Trichet highlighted the importance of speeches by individual ECB Board members, which he said help flesh out the thinking of the Board as a whole. And in this regard, some Board members have been quite clear in pointing to further rate cuts ahead. ECB Board member Tumpel- Gugerell acknowledged that we are in the midst of a sharp economic slowdown which she said is a “cause for concern”. ECB Board member Ordonez meanwhile, speaking before the Spanish Senate, emphasized that the crisis has drastically changed the inflation outlook, with the global recessionary trend set to trigger a significant drop in inflation rates. An important role in the revision to the eurozone prospects has certainly been played by the sudden deterioration in Germany’s growth outlook, emphasized by the sharper-thanexpected contraction in Q3 real GDP (-0.5%). Beatrice Weder di Mauro, a member of the German government’s panel of economic advisers, warned that a contraction by as much as 1% next year could not be ruled out at this stage.

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Published on  Fri, Nov 21 2008, 14:04 GMT