Easy does it

The downgrade in the FOMC’s projection of US economic growth, and the related decision to reinvest principal payments from its mortgage and agency security holdings into US Treasuries, raise the prospect of a further bout of bond purchases. Were this to happen, the central banks of Europe and Japan could be forced to follow suit (though much would depend on reactions in the currency and commodity markets to any such Fed action).

For sure, some recent data have been disappointing (for example, our tracking estimate for US Q2 GDP is now running around 1% saar, versus the advance estimate of 2.4%). The recent slowing has not been confined to the US. Global steel production has recently tapered off (with weaker readings for July from the US, Germany and China - Figure 1).

More broadly, recent trends in industrial production have been flattening out or even edging lower in many countries (Figure 2), partly reflecting base metals and (in Europe’s case) autos (as scrappage incentives are replaced by intensified fiscal consolidation).

Although the global trend in trade volumes had been improving until June, there has been some recent significant slowing in Chinese import data (up to July – Figure 3), with exports to China from Japan, Taiwan, the US and Germany all slowing (in seasonally adjusted terms).

In our view, the recent signs of moderation in China, particularly for steel output, are mainly related to investment, which in turn reflects a moderation in government-sponsored investment, including tighter controls on new projects and bank credit (see China Outlook).  Therefore, the cooling has been policy driven, in line with the official objective of a soft landing. With inflation risks under control, there continues to be significant policy flexibility (particularly with respect to administrative measures) that would limit the risk of a hard landing.

At a global level, we continue to view the recent softening as a lull before a subsequent resumption of activity, rather than the prelude to a major slide. Moreover, in our view, the recent softening in some sectors, such as steel, is being offset by ongoing strengthening in others, namely capital goods. The confidence of CEOs of major global companies appears still to be positive, buoyed by positive earnings reports, lean inventories, and balance sheets.

This suggests that during H2 business investment should continue to drive activity. Still, the Fed’s reassessment reminds us that corporate sentiment can be fickle, particularly in the presence of volatile financial markets. At a time of minimal core inflation pressure in most advanced economies, we believe it is in central banks’ interest to do all they can to shore up confidence in the markets and, more broadly, to allow the more traditional economic cycle (stronger corporate confidence getting traction in the labour market) to take root. While it is still hard to calibrate with much precision the effect of central bank asset purchases on real activity, we can be fairly certain that central banks can avoid deflation if they try hard enough – a lesson that the Bernanke Fed in particular appears to be following closely.

While the Fed appears relatively uninhibited about the prospect of engaging in a substantial further round of asset purchases if warranted by its economic assessment, central banks in emerging economies seem likely to go slowly on further increases in rates. For example, although its own business survey data for August remained at lofty levels, the Bank of Korea refrained from raising its policy rate this week (though it adopted a relatively hawkish tone). We have revised down our estimate of future tightening by the Central Bank of Brazil to one further 25bp increase (while the Central Bank of Chile has continued to normalise rates, reflecting national considerations). Overall, there is still scope for emerging economies to engage in fiscal and monetary/administrative stimulus to support demand if needed. At the G20 level, short–term interest rates are well below the recent pace of nominal GDP expansion – fundamentally, global monetary policy remains very expansionary (Figure 4).

Furthermore, while grain prices have been firming, the food price outlook is different to the 2007-08 episode. The USDA this week lowered its estimate for 2010-11 global wheat production by 15mn tonnes from a month earlier, with Russian production (in tonnes) lowered by 8mn, the EU by 4.3mn, Ukraine by 3mn and Kazhakstan by 2.5mn. In the view of BarCap Commodity Research, we expect grains prices to edge higher in the near term, galvanised by recent supply shortfalls, higher corn demand, adverse weather and the potential for further governmental intervention. Still, the level of global wheat inventories, at 174.8mn tonnes, is substantially above levels in 2007-08. Whereas the consequences of the 2007-08 episode were important for inflation and monetary policy in many emerging economies, the latest cereal market developments have so far not been sufficient to warrant significant CPI revisions in most of the countries we monitor (see also Euro Infocus, in which we project euro area inflation to be 0.1pp higher this year and next).

source: BarCap