Volume 59, Number 3 | April 15, 2011
Pressure bursts pipes, but it also makes diamonds. The global economy has been in a bit of a growth scare recently as rising oil prices act as an unwanted tax hike. Meanwhile, the consequences of the Japanese earthquake have revealed the fragility of global supply chains. The slowdown has reminded politicians that economic imbalances may not resolve themselves through growth, so they are once again considering lending a helping hand. In the US, the Republicans have floated the Ryan plan, the President responded, and the Group of Six Senators is standing in the middle. It’s messy, but at least they are talking – and about topics, like healthcare and taxes, that were unapproachable just a month ago. In Europe, the three little PIGs are all back in trouble again, but this time Germany is suggesting that it might participate in a refinancing. In China, Premier Wen Jiabao has made taming inflation the countries first priority in a number of high profile speeches. Bottom line, it takes crisis to bring about political consensus and action. Hopefully, this grow scare will spur the world’s lawmakers to lay the groundwork for a better balance in the world economy, allowing businesses to get on with the business of business.
Putting on the Suicide Squeeze
As a lifetime baseball aficionado, my favorite play has always been the suicide squeeze. Put on in the late innings of a tight game, the manager starts his man from third before the pitcher releases the ball counting on a sacrifice bunt to bring in the run. The play risks everything, for if the batter misses the bunt the runner is surely dead at the plate – hence the name. The play shows the manager’s confidence in his players, for if they fail he is clearly the goat.
Federal Reserve Chairman Ben Bernanke’s confidence that the core PCE deflator is the correct measure of inflation in the face of growing opposition has the US economy headed for a suicide squeeze. In March, the core CPI rose just 0.1%, and is up a modest 1.2% over the past twelve months. Meanwhile, the headline CPI was up a whopping 05% and has risen 2.7% over the past year – well above many analysts 2% comfort zone. The soft core reading reinforces Bernanke’s view that inflation is still well behaved while unemployment is still too high. He sees rising energy prices as a tax which saps consumer buying power, not a threat of future inflation. Unless wages rise or consumers start taking on more debt, neither of which is happening, it is hard for businesses to pass through price hikes. As a result, we see no tightening in US monetary policy any time soon.
However, the risk in this position is clear from the growing pressure in the inflation pipeline. Never mind energy, crude non-food prices ex-energy rose a torrid 19.2% over the past twelve months. Core PPI for intermediate goods is up 5.6% and import prices ex-petroleum are up 4.1% over the same period. Yet, the core PPI for finished goods is up only 2.0% and the core CPI for goods is up just 0.2% over the past year. Bottom line, little of the inflation so obvious in the pipeline is being passed on as businesses absorb the hit in still fat profit margins. The margin squeeze is most obvious in weak readings like this month’s NFIB, which shows small businesses still are not hiring. Meanwhile, larger firms are offsetting the price hikes through cost control on wages, capital investment and an ongoing shift offshore to cheaper sources of labor. If limited wage growth and rising energy costs cool the economy and inflation, Bernanke wins and growth should rebound as inflation ebbs. However, if sustained energy price hikes push the US into stagflation, not only is he the goat – but it will cause monetary policy everywhere to focus on headline inflation regardless of what’s going on in the core. Bottom line, the game is on the line.
More Men on the Job — Not
The strongest part of the US economy remains manufacturing, with industrial production up 0.8% in March, and up 0.7% for manufacturing. The strong manufacturing sector is reflected in PMI figures like today’s Empire Index, which was up to 21.7 from 17.5 in February. Unfortunately, manufacturing growth does not turn into many jobs due to high productivity gains. Though factory output is up 7.1% over the past twelve months, hours worked in the manufacturing sector are up just 2.9%, with output per hour up 4.1% — well ahead of the 1.7% average for the entire economy during 2010. Moreover, a significant part of the strength in industrial production in the past three months has been from vehicle production – up 17.5% (not annualized) from 7.61 million units at an annual rate to 8.94. This area is likely to be hit hard by the Japanese supply chain woes before popping back up in the second half of the year. We will be watching initial unemployment claims data at the state level, as well as anecdotal reports on supply chain breakdowns, to monitor the situation. A sag in auto production could soften second quarter GDP expectations from the current 3.5% range – just as a weak Christmas and bad weather slowly eroded expectations about growth in the fourth quarter of 2010 and the first quarter of 2011.
China Hits the Brakes Again
China announced a raft of statistics Friday that show the economy is still booming – and with a tremendous inflation problem. As a result, they announced the fourth increase in their reserve requirement this year, up 0.5% to 20.5% for most banks. Inflation is still too high, bank loans are still growing too quickly and hot money is flooding in to take advantage of either rising interest rates or an appreciating currency. As more dollars and other foreign currencies are exchanged into yuan as deposits at Chinese banks, the government buys up the currency and issues new yuan in order to protect its exchange rate. To absorb the yuan and keep money supply from exploding, the government issues new bonds and raises bank reserve requirements so they can’t make new loans. Raising interest rates like the 25 basis point hike two weeks ago (also the fourth time this year) should also help cool the economy – but it attracts in more hot money. Following Premier Wen Jiaboa’s comments that fighting inflation was the nation’s number one goal, many investors expect accelerating yuan appreciation and are making fresh yuan deposits to benefit from the trend. Given the strong correlation between inflation reports and monetary tightening, it seems likely that China will hike both interest rates and the reserve requirement several more times this year. However, given their lack of experience in the estimating the lags with which monetary policy works, it also greatly increases the risk of a policy mistake. Stay tuned.
China’s real GDP was reported up 9.7% for the year ended 2011 Q1. This is just slightly different than the 9.6% and 9.8% reported for the fourth and third quarters of 2010, respectively. Meanwhile, China reported that nominal yuan based GDP was up 18.1% in the first quarter compared to a year ago. This implies a 7.7% growth rate in the GDP deflator. Meanwhile, the Chinese reported that CPI was up 5.4% in the year ended March 2011, or 5.0% for the first quarter compared to a year ago. If consumer prices, which represent less than half of GDP, are up just 5% over the past year, then non-CPI inflation must be running over 10%. Higher inflation in the construction and government sectors makes sense given the building boom and easy credit. Meanwhile, controlled prices outside of food and energy keep consumer inflation down. Still, core CPI was up 2.7% from a year ago in March – the highest rate in ten years – suggesting there may be a lot more tightening on the way.
This month the Chinese began reporting real GDP not only as a percent change from a year ago, but also the quarter to quarter change on a seasonally adjusted basis, not annualized. In the first quarter, real GDP rose 2.1%, slowing from a 2.4% growth rate in the fourth quarter. This implies a steady growth rate at 2.4% in the second and third quarters of 2010 as well. The slowdown to an 8.7% annual rate in the first quarter of 2011 may be factual or a step toward the slower growth expected in the new five year plan. Not enough detail is yet available on the new quarterly growth patterns – and all Chinese data must be taken with a grain of salt. Still, better statistics are a welcome development and we hope they help illuminate more near term trends in China.
On a scarier note, China’s dollar denominated GDP reached $6.65 billion in the first quarter of 2011 – up about 22% from a year ago when one adds 3.6% yuan appreciation on top of 18.1% growth. Yuan appreciation should accelerate to at least 5% this year as they fight inflation. If Chinese dollar based GDP grows 20% over the next year (which seems highly likely) and the US grows 5% nominal, China’s GDP will be more than half the US at the start of 2012. That is almost 50% larger than Japan – which they just passed a year ago – and equal to Germany, France and Italy combined. China already represents more than 10% of world GDP, and its 20% dollar denominated growth rate means its buying power is rising by 2% of world GDP a year. China’s imports and exports are growing even faster (over 30%) due to foreign outsourcing to their low cost factory floor and domestic demand. As the driver of global growth and trade, a policy mistake there is far more important than anywhere else in the world – and they are well outside their comfort zone in the current policy mix. Barring a mistake, their global influence will grow only larger each year. Bottom line, the next major global event will not be a Lehman, or PIGs crisis, or a Japanese earthquake – it will be made in China. The question is when and how will it ripple through the rest of the world? We watch everywhere, but we worry most about China.