Weekly Economic and Financial Commentary

U.S Highlights

• Housing starts plunged 14.3% in January.
• The PPI fell 0.6% in January and the core PPI rose 0.2%.
• The U.S. trade deficit widened in December and business Inventories were unchanged.

International Highlights

• The Japanese economy grew at its strongest rate in nearly three years in the fourth quarter. In the United Kingdom, weaker-than-expected economic data reduced the probability of multiple rate hikes ahead.

Point of View

• From our viewpoint, energy and food prices remain the primary non-labor risk on inflation (left graph).
• By developed nation standards, retail sales growth in China is robust (right graph). However, consumption as a share of GDP has fallen for the last decade, concerning the country’s leaders. Reforms in education, health care and pensions are proposed, but the solution may eventually come from private housing markets.

U.S. Developments

The Soft Landing Story Is Now More Believable

The debate about whether or not the Fed would be able to achieve a soft landing is over. Ben Bernanke has brought the economy in for a near perfect soft landing. Debate is about evenly split as to whether the next Fed move will be to raise or lower interest rates, which is exactly where it should be when the economy is in the early stages of a soft landing.

For the benefit of those who were not following the economy closely back in the mid-1990’s, which was the last time the economy was in a similar position to where it is today, a soft landing is a period of two or more quarters where real GDP growth slows below the economy’s long run potential growth rate of 3 percent. Soft landings are sometime referred to as “the pause that refreshes” because they tend to open up a little slack in the economy and subdue any budding inflationary pressures. With inflation lower, interest rates either hold steady or fall back a bit and pave the way for stronger growth in coming years.

Initial reports for the fourth quarter show the economy expanding at a 3.5% pace, which would be inconsistent with a soft landing. This past week’s reports on the nation’s trade deficit and business inventories, however, suggests the initial GDP estimate will be revised down by about a percentage point to 2.5 percent. The nation’s trade deficit widened by $1.4 billion in December, to $61.2 billion. Business inventories were unchanged for the month. The BEA had assumed a smaller trade gap for the month and also looked for inventories to increase.

Another piece of weaker economic news reported this week was that industrial production fell 0.5% in January. Declines were broad based, with output falling sharply for both consumer goods and capital equipment. Motor vehicle production fell by about 1 million units at an annual rate, as the major motor vehicle producers continue to strive to reduce inventories. The only bright spot was utility output, which jumped 2.3%, as winter weather finally returned to the East Coast.

The slowdown in industrial output cut capacity utilization by 0.6 percentage points to 81.2. The long-run average for capacity utilization is roughly 81 percent, and the utilization rate would have to drop well below that level before the Federal Reserve, which produces the data, would consider cutting short-term interest rates.

The return of winter weather also apparently led to a much sharper cutback in housing starts during January. Starts plunged 14.3% to a 1.408 million unit pace, which is the lowest level for housing starts in ten years. There is no doubt that the weather influenced this number. Building permits were down much less, falling 2.8% to a 1.57 million unit pace. The decline, however, underscores some of the points we made in our Housing Chartbook, released yesterday. Once you cut through the volatility in the monthly starts data, we still feel that the housing market has a bit further to slide before it bottoms out.

The inflation data looked a little better this week, with the Producer Price Index falling 0.6% in January and the core rising just 0.2%. On a year-to-year basis, the PPI is currently up 0.2%, while the core is up 1.8%. Pressures on inflation are cooling further back in the production pipeline. Prices for core intermediate goods were unchanged in January versus December and have been essentially unchanged for the past six months. By contrast, core intermediate goods prices one year ago were up 4.9% on a year-to-year basis. In the past, such moderation has resulted in some cooling of core inflation at the consumer level and paved the way for a Fed easing.

Retail sales for January were a slight disappointment. Sales were unchanged in January and rose just 0.3% after excluding the volatile motor vehicle sector. Data for December were revised higher, however, which helps explain why inventories rose less than expected.

International Developments

Japanese GDP Growth Surprises to the Upside.

As shown on the front page, Japanese real GDP grew at an annualized rate of 4.8 percent in the fourth quarter of 2006 relative to the previous quarter, the strongest quarterly growth rate in nearly three years. Moreover, the breakdown of GDP into its underlying demand components showed that strength was broad based in the fourth quarter. Indeed, growth in final sales to consumers, businesses and the government was equal to the overall GDP growth rate.

The stronger-than-expected data have raised the probability that the Bank of Japan (BoJ) will tighten monetary policy further, and the yen, which has been getting pounded lately, strengthened versus the dollar. Indeed, the dollar depreciated across the board this week due to weaker-than-expected U.S. economic data and comments by Fed Chairman Bernanke that were not as hawkish as some market participants had feared. As shown below, the Fed’s “Major Currency” index, which measures the dollar’s value versus seven important foreign currencies, fell to its lowest level in more than a month.

Enough about the dollar. Let’s get back to the yen. Some analysts fear that rising Japanese interest rates could lead to a sudden unwinding of so-called yen carry trades whereby some market participants finance high-yielding investments by borrowing yen at low interest rates. A sudden unwinding of these trades could lead to extreme turbulence in global financial markets, à la October 1998. Does trouble lie ahead?

In our view, the probability of near-term financial market volatility associated with sharp unwinding of yen carry trades is rather low. First, we’re not convinced the BoJ will hike rates next week. The government pressured the BoJ not to raise rates at its policy meeting last month, after BoJ officials had been suggesting to anyone who would listen that a rate hike was imminent. Although Q4 GDP growth was stronger than expected, the BoJ may not be able to credibly argue that enough has changed in only a few weeks to make a rate hike necessary now.

More importantly, yen carry trades would be threatened only if Japanese interest rates rise faster than investors currently expect. The Japanese yield curve is currently priced for roughly 50 basis points of rate hikes over the course of the year. Unless inflation picks up suddenly, which does not seem to be very likely, a very gradual pace of tightening over the next few quarters seems reasonable. Therefore, we do not expect yen carry trades to “blow up” anytime soon.

U.K. Economic Data Lead to Reassessment of Rate Hikes

If the Japanese yen was the star performer against the dollar this week, then the British pound was the underachiever. As shown below, CPI inflation fell from an eleven-year high of 3.0% in December to 2.7% in January. Although the inflation rate remains well above the Bank of England’s medium-run target of 2.0%, January’s outturn was not as high as most investors had expected. In addition, the volume of British retail sales dropped 1.8% in January relative to the previous month, which was also weaker than expected.

Although a rate hike at next month’s policy meeting still seems like a reasonable bet, the data reduce the probability that a series of rate hikes lie ahead. The Bank of England has tightened policy by 75 basis points since August, and some slowing of growth should be expected due to the lagged effects from higher interest rates. Sooner or later, the Monetary Policy Committee will want to pause to see how the economy is responding to the medicine of higher rates. The U.K. yield curve, which two weeks ago had been priced for 50 basis points of tightening by summer, now expects only one more 25 basis point rate hike before the Bank goes on hiatus.

Interest Rate Watch

Economic and Inflation Outlook : The Fed

At present, no changes are anticipated in the federal funds rate for this year. This view was reinforced by Chairman Bernanke’s latest testimony. From the Fed’s view it appears that growth will be more moderate than the Fed earlier expected. The Fed lowered its central tendency outlook for 2007 to 2.5 percent to 3.0 percent which compares to our outlook for 2.6 percent. Meanwhile, core inflation is anticipated to be in the 2.0 percent - 2.25 percent range for 2007. Our outlook is for 2.3 percent. As a result, our outlook suggests there is no need to alter the funds rate going forward.

Risks?

For the Fed, the predominate risk is that inflation will not moderate as anticipated. From our viewpoint, energy and food prices remain the primary non-labor risk on inflation. Meanwhile, the decline in productivity gains at this stage of the business cycle suggest that a given pace of compensation gains that unit labor costs will rise and thereby pressure prices upward. At this point our outlook is that the core PCE deflator, the perceived Fed inflation benchmark, does not fall into the Fed’s preferred range of 1.5-2.0 percent. Therefore, we do not see that the Fed has room to ease policy given a pace of real growth in the 2.5 to 3.0 percent range.

Capital inflows remain the major external risk to the economy. Chairman Bernanke mentioned our dependence on these capital flows from abroad. Historically, such flows do diminish when investors perceive a significant decrease in the expected rate of return. For decision-makers, these returns would be threatened if it were perceived that entitlements and inflation commitments were either not being met of were being met in a negative way.

Topic of the Week

Woe Is (Still) the Chinese Consumer

China has been one of the fastest growing economies in the world for thirty years, but the composition of growth is worrying policymakers. While business investment and foreign trade have catapulted the country’s economic growth, China’s consumers have largely been left behind. Consumer spending accounts for only 50 percent of nominal GDP, down a full 10 percentage points over the last decade.

As a result, political leaders agreed to alter China’s growth strategy beginning in 2004. Short-run efforts to stimulate consumption via tax cuts resulted in some growth in retail spending (retail sales in China represent about 2/3 of total consumption), but sales growth moderated again last year (graph on front page). Now what?

It appears that the best long term solution to the problem of falling consumption rates is to attack the reasons for high Chinese consumer saving. Chinese consumers saved 37 percent of their income in 2005, and likely saved even more last year. Consumers report that they save primarily for housing, education, health care, and pensions.

Health care and pension reform will be most difficult to tackle, so leaders have chosen first to reform the system of education, which in China is compulsory, but not free. Beginning this year, fees for education in rural areas will be eliminated, relieving one burden on the rural population.

Meanwhile, housing could be the unintended white knight in this story, particularly as housing costs are a primary concern for the wealthier urban consumer. As pent-up demand for housing wanes, discretionary income should be freed up for spending on other goods and services. It could be a long shot to expect housing demand to ease, but it just may be the natural solution to a difficult problem for China.

Next Week’s Highlights

• Domestically, the week will be extremely light with CPI and Leading Indicators leading the way.
• Internationally, the BOJ will announce its target rate, which is expected to remain at 0.25 percent. French GDP, German Final GDP and Canadian CPI will also be hot indicators to watch.

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