Market Economics | Interest Rate Strategy - BNP PARIBAS ...

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this juncture, we believe that looking at the FMCI rather than just at interest rates has become more important. Our latest Global Outlook contained a detailed report on FMCIs around the world. The broad summary is shown in Charts 4 to 8. Financial and monetary conditions in the US are soft, very soft (Chart 4). Our FMCI is about one and half standard deviations below average, compared with a low since 1990 of two and a half standard deviations. In the eurozone, conditions are 0.3 standard deviations below average (Chart 5) with UK conditions, as in the US, one and a half standard deviations below average. Canada’s reading is similar. Japanese conditions are slightly tighter than average, mostly reflecting the yen. Overall, advanced country monetary and financial conditions are about a standard deviation softer than the long-term average (Chart 6). In emerging markets, our FMCI for China has remained accommodative, with the latest reading showing conditions about a standard deviation softer than average (Chart 7). Korean and Brazilian FMCIs are softer than average, India’s is about average and Mexico’s is above average. Overall, our latest readings are that, in Latin America as a whole, FMCIs are a bit softer than average. In Asia ex Japan, they are about a standard deviation below average (Chart 8). Overall, the picture is of very soft monetary conditions in the west, especially the US, Canada and the UK, less so in mainland Europe and restrictive in Japan. In emerging markets, conditions look more or less neutral in Latam but with offsetting pictures in Brazil (soft) and Mexico (tighter than average). Asia looks soft. We have to judge these monetary conditions relative to where they ought to be, given inflation and the output gap. US and European conditions look to us to be appropriate – softer than average due to low inflation in core terms and still excess capacity. Given some parts of the eurozone are softer than others, monetary conditions within the eurozone are probably too soft for Germany and too tight for Ireland and Spain, for example. Japanese conditions look too tight. Source: BNP Paribas Source: BNP Paribas Source: BNP Paribas Chart 4: US FMCI Chart 5: Eurozone FMCI Chart 6: Advanced Country FMCI Chart 7: China FMCI We would argue that monetary conditions in emerging markets should be tighter than average given the lack of spare capacity and inflation starting to swell. In Asia, conditions violate this the most, including in China, helping to explain recent tightening moves. Brazil is also in the ‘far too soft’ camp, but Latam as a whole is neutral when it should be restrictive. Source: BNP Paribas Paul Mortimer-Lee 20 January 2011 Market Mover 6 www.GlobalMarkets.bnpparibas.com
US monetary conditions, because the USD is the global reserve currency, also affect countries which peg or dirty float against the USD. Many of these have output gaps and inflation dynamics that are hugely different from those in the US. Importing super-soft US monetary policy is bound to lead to them having an inflation and asset-price risk. It appears to us that very few of these countries have excessively tight monetary policy, which is the usual excuse for their intervening to hold currencies down or using ‘macro-prudential’ policies (aka capital controls) to achieve the same ends. In fact, most of them have monetary policies that are too soft. We would argue that this is their choice and that inflation is a very likely result. They will see their exchange rates appreciate in real terms against the USD through excess inflation. Our preference would have been for nominal exchange rate appreciation, which would contain inflation, not aggravate it. Overall then, monetary conditions look too soft for a world where inflation is developing some hotpots and where capacity is used up. Asia is most vulnerable, Latam a bit less so. Expectations Economic theory puts a big weight on inflationary expectations in the story of how inflation is propagated. Unfortunately, these are difficult to model and predict and they may shift in a discrete way. The process by which inflation expectations are formed is probably one where they depend upon: • What people experience; • What central banks do; and • What central banks say. This determining relationship may not be stable. For example, in the UK, people have been experiencing significantly above-target inflation for a long time. The longer this continues, the greater the weight is likely to be on what they experience and the less the weight will be on what the Bank of England says. Therefore it may have to raise rates to keep inflation in check. We do have measures of inflation expectations for various countries, but for our purposes here we would like a consistent measure. The Ifo institute provides a measure of inflation expectations, with Charts 9 to 14 (attached) summarising the picture. What we find is that, after the financial crisis, inflation expectations plunged. There was a clear danger everywhere of this undermining activity and leading us into deflation, at least in some of the most important economies. Aggressive monetary policy counteracted this and inflation expectations rose sharply in late 2009-early 2010. These overshot – reaching levels similar to Chart 8: Latam and Asia Ex-Japan FMCI Source: BNP Paribas those at the peak of the cycle in 2007 – and have since come back, especially in North America and Western Europe. The current picture is: • Inflation expectations in North America are very low, and declining, though not as low as in late 2008/early 2009 when deflation was being expected. There is no threat to inflation from inflation expectations in N America. • Inflation expectations in Western Europe have come back from their peak, which was the highest in two decades. We should not concentrate on the fall since then as it was probably an exaggeration. The level of inflation expectations compared with the average since EMU began in 1999 is moderate to strong. Clearly, as the ECB has shown in its recent press conference, they want watching. • Inflation expectations in the CEE countries are worryingly high and on a sharp upward trajectory. CIS expectations are also high. • Asian inflation expectations have not come off their peak very much. They are high, though not as high as in the early-2008 food price scare episode. Nonetheless, with monetary conditions slack, inflation expectations in Asia look uncomfortable and deserve very close monitoring, especially as food price surges look to have an important impact in the inflation story. • Latam inflation expectations are high, even though they are lower than the peaks at the end of the last cycle and the 2010 ‘QE will cause inflation’ scare. Central banks are talking about achieving price stability, but decisive action is not being taken (e.g. Paul Mortimer-Lee 20 January 2011 Market Mover 7 www.GlobalMarkets.bnpparibas.com
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Page 29 and 30: Japan: Capex Outlook • Core machi
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Germany 10y: MT 61.8% (3.12) break
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Travelling Asia • Inflation has e
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Capitalism requires business cycles
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EURUSD Rally Eyes 1.3750-1.3950 •
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Currency Spot Trade Recommendations
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than an unrelenting rise in prices
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Economic Calendar: 21 - 28 January
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Key Data Preview 120 115 110 105 10
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Key Data Preview Chart 5: French Sa
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Key Data Preview 10 5 0 -5 -10 -15
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Key Data Preview 3 2 1 0 -1 Chart 1
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Economic Calendar: 31 Jan - 25 Feb
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Next Week's T-Bills Supply Date Cou
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Economic Forecasts GDP Year 2010 20
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Market Coverage Market Economics Pa
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