BoJ lowers growth forecast, raises inflation forecast

Normalisation of interest rates in Japan has been put off again. Reuters reports the latest BoJ forecasts.

Japan's central bank, facing sharply weakening growth in the economy as soaring raw materials costs bite, gave up its long-standing bias to raising rates on Wednesday and governor Masaaki Shirakawa warned that downside risks were likely to dominate over the next year.

"If we look at the prospects for 2008/09, we are putting more emphasis on downside risks than on upside risks," Shirakawa told a news conference after a review that held Japan's key interest rate unchanged at a low 0.5 percent, as expected.

For the first time in two years, the bank dropped from its half-yearly report on the economy its mantra of gradually "adjusting" Japan's low rates towards more normal levels.

The BOJ cut its growth outlook for the year to next March to 1.5 percent from a previous 2.1 percent forecast and almost tripled its inflation outlook to 1.1 percent for the year, up from 0.4 percent in its last half-yearly report in October.

There were plenty of economic data out of Japan today, and as the Reuters report said, they were "almost relentlessly downbeat".

The downgraded in Japan's growth outlook followed the release of figures showing its industrial output fell 3.1 percent in March -- the biggest monthly fall for at least five years and far bigger than market forecasts for a 0.8 percent drop...

Seasonally adjusted unemployment dipped to 3.8 percent in March, government figures showed. That was better than the flat 3.9 percent expected by economists, but they focused instead on a fall in the ratio of job offers to job seekers.

The ratio slipped to 0.95, meaning 95 jobs were available per 100 applicants, below a median forecast of 0.96 and continuing a fall from a peak of 1.07 last June...

Overall household spending fell 1.6 percent in March from a year earlier in price-adjusted real terms, countering a median market forecast for a 0.5 percent increase and further signaling weak consumer spending...

... Housing starts, hit by a regulatory change last year, fell 15.6 percent in March from a year earlier, government figures showed, below a median market forecast for a 6.7 percent drop.

The NTC Research/Nomura/JMMA Purchasing Managers Index, which gives an early snapshot of the health of manufacturing, declined to a seasonally adjusted 48.6 in April from 49.5 in March and was the lowest since 48.1 in February 2003. A reading below 50 points to a contraction in manufacturing activity.

Europe to slow into 2009, German inflation falls

The European Commission sees the European economy slowing through 2009. Reuters reports:

In its twice-yearly economic forecasts for the euro zone and the 27-nation European Union, the Commission said growth in the 15 countries sharing the euro would slow to 1.7 percent this year from 2.6 percent in 2007 and to 1.5 percent in 2009...

The Commission expects inflation, which hit a record high of 3.6 percent year-on-year in March, to accelerate to 3.2 percent in the whole of 2008 from 2.1 percent in 2007 and to ease to 2.2 percent in 2009.

But maybe inflation in Europe has already peaked. From Bloomberg:

Inflation in Germany, Europe's largest economy, slowed more than economists forecast in April as an early Easter led to a drop in costs for package holidays and vacation accommodation.

The inflation rate, based on a harmonized European Union method, fell to 2.6 percent from 3.3 percent in March, the Federal Statistics Office in Wiesbaden said today. Economists expected inflation to slow to 3.1 percent, according to the median of 27 forecasts in a Bloomberg News survey. From a month ago, prices fell 0.3 percent.

There are doubts that the fall will be sustained though.

"Today's figure is welcome, but likely to prove a one-off surprise," said Jacques Cailloux of Royal Bank of Scotland Plc in London and one of just three economists in the Bloomberg survey to predict the rate would drop below 3 percent. "I don't think that the data will help to alleviate the ECB's concerns on inflation."

Speaking of the ECB, Jean-Claude Trichet continues to sound as single-minded on inflation as ever. From Bloomberg:

European Central Bank President Jean-Claude Trichet said the bank must set interest rates with the sole goal of maintaining price stability, rebuffing calls from the French and Italian governments for it to take growth into account.

"It's crucial that the Governing Council sets the appropriate monetary policy stance on the basis of no other considerations than the delivery of price stability in the medium term," Trichet said at a conference in Vienna today. The bank's current policy stance "will contribute to achieving our objective," he said.

But while ECB officials have been talking, some of their European counterparts are taking action. Yesterday, Hungary's central bank raised its benchmark interest rate by a quarter of a percentage point to 8.25 percent while outside the EU, the Russian central bank also raised its main interest rates by a quarter of a percentage point.

Japanese data reverse, economy pauses

Earlier reports of the demise of the Japanese economic expansion appear to have been exaggerated. Nevertheless, the outlook for the Japanese economy remains lacklustre.

On 7 April, I had written that Japanese industrial production had fallen for a second consecutive month in February and suggested that the Japanese economy could be contracting (see "Japan looking like the US, US looking like Japan").

That turned out to be a false alarm. The industrial production data were subsequently revised along with a change in the base year from 2000 to 2005. The revised data show that industrial output rose 1.6 percent in February. With this reversal and output projected to rise further by 0.2 percent in March, industrial production is now projected to increase by 0.5 percent in the first quarter.

Nevertheless, it remains true that industrial activity appears to be softening in Japan. The NTC Research/Nomura/JMMA Purchasing Managers Index had fallen to 49.5 in March from 50.8 in February.

Furthermore, the Bank of Japan's Tankan survey in March had shown that the diffusion index for large manufacturers had fallen to 11 from 19 in December. The index has now clearly peaked and is on a clear downtrend. In the past, this has usually been followed eventually by a contraction in industrial production.

Other sectors of the economy are also showing signs of weakness.

The tertiary index, which measures activity in the services sector, fell 1.7 percent in February mainly due to lower spending on financial and insurance services. The fall dragged the all-industries index down by 1.4 percent that month.

The boost to the economy from exports also appears to be diminishing. Exports rose just 2.3 percent in March from a year earlier, the smallest increase since May 2005. Exports to the US fell 11.0 percent. The slower export growth resulted in Japan's trade surplus shrinking 30.2 percent from a year earlier as imports rose 11.1 percent mainly on the back of higher energy prices.

Higher energy prices were also the main driver of higher Japanese consumer prices. Core consumer prices, which exclude fresh food, rose 1.2 percent in March from a year earlier, up from 1.0 percent in February. Excluding food and energy, prices were up just 0.1 percent.

There was one positive economic report last week. The index of leading economic indicators for February showed a revised 54.5 reading, the first time in seven months that the index had moved above 50, indicating that the economy is likely to expand over the next few months.

In addition, the drag on the economy from falling housing activity appears to be diminishing. Data released at the end of last month had shown that housing starts were down just 5.0 percent in February after having declined sharply for much of 2007 following a revision to Japanese construction regulations.

Nevertheless, the Japanese government remains concerned about the risks to growth, noting in its April economic assessment that the "economic recovery appears to be pausing". It warned of downside risks to the Japanese economy arising from the risk of a recession in the US economy, fluctuations in financial markets and oil price trends.

No doubt, those factors will be among the ones that officials from both the Bank of Japan and the Federal Reserve will be most focused on when they meet later this week to determine monetary policy. The latter is expected to cut interest rates by another 25 basis points. Many think it will be the last rate cut for some time to come.

However, with downside risks to the global economy still evident, we could instead see the Bank of Japan making its first rate cut in some time in the not-too-distant future.

US economic indicators at recessionary levels, UK economy slows

Traders may be pricing in an end to Fed easing but the latest economic indicators continue to show a weak US economy.

US consumer sentiment hit a 26-year low in April. Reuters reports:

The Reuters/University of Michigan Surveys of Consumers said its final index of confidence for April fell deeper into recessionary territory, to 62.6 from 69.5 in March and below economists' median expectation of 63.2 in a Reuters poll.

The April result is the lowest since March 1982's 62.0, when the "stagflationary" period of low growth and high inflation was still an issue for many Americans...

The report showed its reading on one-year inflation expectations climbed to 4.8 percent -- the highest since a similar reading in October 1990 -- from 4.3 percent in March.

Consumer sentiment is not the only indicator in recession territory. So is the ECRI's leading index, although here, there are some signs of improvement. Reuters reports:

The Economic Cycle Research Institute, a New York-based independent forecasting group, said its Weekly Leading Index edged up to 132.1 in the week to April 18 from 132 the prior week...

The index's annualized growth rate remained negative, but improved to minus 9.7 percent from minus 10.2 percent. It's the highest since minus 8.8 percent in the week ended February 1.

"WLI growth has recovered to an 11-week high, but remains deep in recession territory, therefore it is premature to forecast a business cycle recovery," [managing director Lakshman] Achuthan said.

Meanwhile, the UK economy is also showing signs of slowing. Again from Reuters:

Britain's economy grew at its weakest rate in three years in the first quarter as the credit squeeze tightened its grip, data showed on Friday.

The Office for National Statistics said the economy grew 0.4 percent in the first three months of the year, down from 0.6 percent in the previous quarter and as high as 0.9 percent at the end of 2006.

US and UK economies show resilience, confidence falls in euro area

Maybe the US economy isn't in such a bad shape after all. Reuters reports that housing continues to be very weak, but we already knew that.

Single-family new home sales slumped 8.5 percent in March to a 526,000 annual rate, the weakest pace since October 1991, while the median sales prices versus a year ago dropped by the largest amount since 1970, the Commerce Department said...

March's fall follows a downwardly revised 575,000 units in February...

The sharp decline in new home sales was in contrast to the more modest 2 percent drop in sales of previously owned homes in March reported on Tuesday.

But March durable goods orders, though down, did provide some positives.

Commerce Department data separately showed that new orders for long-lasting U.S. made goods unexpectedly fell 0.3 percent in March after transportation orders slumped, compared with economists' forecasts for no change.

New orders excluding transportation rose 1.5 percent, while transportation equipment fell 4.6 percent, including a matching drop in motor vehicles and parts which was the steepest drop since last August...

Nondefense capital goods orders excluding aircraft...was unchanged as forecast and the previous month was revised up to show a 2.0 percent decline, from a 2.4 percent drop reported before.

But shipments of this so-called "core" measure of capital spending jumped by 1.2 percent, possibly hinting at stronger foreign demand for U.S. equipment, while inventories in this category increased by 1.0 percent.

The labour market is also showing resilience.

The number of U.S. workers filing initial claims for unemployment benefits fell by 33,000 last week to 342,000, the Labor Department said, compared with economists' forecasts for 375,000 new claims.

The four-week moving average of new claims...eased last week to 369,500 from 376,750.

That reinforces the view that Fed easing may be near an end.

Interest rate futures markets had fully priced another quarter percentage point Fed ease at the meeting on April 29-30. But these chances were reduced to show only about an 80 percent likelihood the central bank would move after Thursday's data, which also showed initial jobless claims fell last week and durable goods orders exhibited some resilience in March.

There was also surprising resilience in the UK economy. From Reuters:

The Office for National Statistics said retail sales volumes dipped 0.4 percent in March, broadly as expected, but upward revisions to back months lifted the annual rate to a pacey 4.6 percent.

The three-month on three-month growth rate, seen as a better gauge of the underlying trend, rose to 2 percent -- the highest rate since July 2006...

However, a survey of manufacturers by the Confederation of British Industry painted a far more gloomy picture. Order books in April were in their worst shape since October 2006, having deteriorated on the month at the sharpest rate on record.

The eurozone economy, though, may be taking a turn for the worse. From Bloomberg:

Business confidence in Germany and France, which account for about half the euro-region economy, slumped in April as record oil and food prices stoked inflation.

The Munich-based Ifo institute said its business climate index, based on a survey of 7,000 executives, fell to 102.4 from 104.8 in March. That's the lowest since January 2006. In France, sentiment among 4,000 manufacturers slid to a 16-month low of 106 from 108, Insee, the Paris-based national statistics office said...

Italian consumer confidence held near the lowest level in four years and Dutch consumer sentiment declined to the lowest in more than two years, reports showed today...

Norges Bank hikes rate to 5.5 percent, inflation worldwide continues to accelerate

New Zealand left interest rates unchanged at 8.25 percent today but Norway must be yearning for New Zealand's rates. From Bloomberg:

Norway's central bank raised the benchmark interest rate to 5.5 percent, the highest since April 2003, on concern a slowdown in economic growth will fail to shackle inflation.

Norges Bank increased the deposit rate by a quarter point...

The bank's preferred measure of inflation, which excludes energy and taxes, slowed to 2.1 percent in March, above the central bank's forecast of 2 percent.

In contrast, Norway's neighbour Sweden isn't in any hurry to get any closer, at least as far as interest rates are concerned.

Sweden's Riksbank, left its repo rate unchanged at a six-year high of 4.25 percent today and reiterated it would leave borrowing costs unchanged until 2010 to bring inflation below the 2 percent target. Inflation accelerated to a five-year high of 2.3 percent in March.

For all its tough talk and inflationary data (see for example Macro Man's analysis), the European Central Bank is more likely to emulate the Riksbank for the time being, especially after the mixed economic reports yesterday. From Bloomberg:

Royal Bank of Scotland Group Plc said a preliminary estimate of its services index rose to 51.8 from 51.6 in March. Economists expected a decline to 51.4, according to the median of 38 forecasts in a Bloomberg News survey...

RBS's gauge of manufacturing activity fell more than economists forecast to 50.8 from March's 52. The composite index of services and manufacturing rose to 51.9 from 51.8.

Industrial orders held up well in February.

Euro-region industrial orders rose 0.6 percent in February from the previous month, boosted by aircraft and other transport equipment, the European Union's statistics office said today. Economists expected a 0.4 percent decline, according to the median of 17 forecasts in a Bloomberg survey. From a year earlier, orders grew 9.9 percent.

However, there are ominous signs. Again from Bloomberg:

Belgian business confidence fell by a record this month on concern the euro's gain against the dollar and soaring food and energy costs will curtail economic growth.

The business-confidence index, considered a leading indicator for Europe, fell to minus 7.9, the lowest since August 2005, from 1.2 in March, the nation's central bank said today in Brussels. The decline exceeded analysts' forecasts and was the biggest drop since the bank began the index in 1980.

Elsewhere, though, inflation remains a big concern.

Australia's inflation rate soared to a six-year high of 4.2 percent in the three months to March. That helped drive the Australian dollar yesterday to the highest level since 1984.

Inflation in Singapore rose to 6.7 percent last month, the highest rate in 26 years. The Singapore dollar also touched another record high yesterday. This is likely to be a routine from now on if the Monetary Authority of Singapore seriously hopes to fight inflation.

One central bank that surely has to treat inflation seriously is the South African Reserve Bank. Despite interest rates now at 11.5 percent, South African inflation accelerated to an annual rate of 10.1 percent in March, the highest in more than five years.

Oil hits record high, BoC lowers interest rate

Crude oil hit another record high yesterday. Bloomberg reports:

Crude oil rose to a record $119.90 a barrel in New York as the dollar dropped to an all-time low against the euro, prompting investors to purchase commodities as an inflation hedge.

Oil gained as the dollar touched $1.60 per euro for the first time after European Central Bank policy makers signaled they may raise interest rates because of inflation. Crude's 24 percent surge this year pulled gasoline and diesel to records, weighing on an economy already reeling from a credit crisis...

The falling dollar and higher global demand for raw materials have led to records this year for commodities including gold, corn, soybeans and rice. The UBS Bloomberg Constant Maturity Commodity Index, which tracks 26 raw materials, gained 1.2 percent to 1521.008 today, up 37 percent from a year ago.

The rising prices of commodities, however, didn't stop the Bank of Canada from cutting its benchmark rate again yesterday. Bloomberg reports:

The Bank of Canada lowered its benchmark rate by half a point to revive an economy that's growing at its slowest pace in 16 years, and signaled more easing may be needed.

Governor Mark Carney and his five deputies cut the rate on overnight loans between commercial banks to 3 percent, the lowest since December 2005, a move predicted by 28 of 32 economists in a Bloomberg News survey.

The projections for growth and inflation in the central bank's statement today indicate policy makers may ease again as soon as their next meeting on June 10, economists said. The bank cut its 2008 growth forecast to 1.4 percent, the lowest since 1992, from a January prediction of 1.8 percent, and said inflation will stay below their 2 percent target until 2010.

As BoE fights credit crunch, is inflation the greater threat?

The Bank of England has come up with its own plan to avert a credit crunch. From Reuters:

The Bank of England detailed a ground-breaking plan on Monday to lend banks around 50 billion pounds to help them operate during the credit squeeze.

It said it would allow banks to swap mortgage-backed bonds which have become hard to trade for specially-issued Treasury bills.

This would free up banks' balance sheets, allowing them to lend more to households facing a dwindling choice of mortgage options and declining property values.

However, in view of the rather severe haircuts that banks using the facility will have to take, it remains to be seen how much banks will actually use it.

In any case, maybe a credit crunch isn't the worst thing to worry about. From Merrill Lynch analysts TJ Bond and Alex Patelis writing at the FT:

[D]omestic bank lending globally has not been significantly affected... [T]he impact of the credit crunch has largely been confined to capital markets...

[C]redit crunch or not, the arguments for strong growth in emerging markets – underinvestment, insufficient infrastructure, favourable balance sheets, rising consumer income and a growing middle class – have not changed. Emerging markets account for more than half of global growth; we expect that share to rise over the next few years...

The risk for policy is that concerns about growth may make central banks hesitant to tighten. Indeed, the big surprise for 2008 so far has been the surge in inflation, not the cut to growth.

Focused on the credit crunch, central banks could miss the message in commodity prices. Especially in emerging markets, the loss of macro stability as inflation becomes entrenched could prove far more damaging than the short-term headwinds from the global credit crunch...

Tim Duy says that even in the US, it may be "time to think about the other side".

[E]conomic downturns do not last forever, and the current episode is no exception. Ever since last summer, the yield curve, particularly the 10-2 steepness, has been sending a signal that I find difficult to ignore – a signal that the technical recession will be rather shallow and short-lived. Indeed, the 10-2 spread currently is consistent with the end rather than the beginning of a downturn...

Bottom Line: I suspect the cessation of rate cuts is near at hand... It will soon be time to turn our attention to timing the next tightening cycle. Expected job market/housing weakness argues for an extended period of low rates similar to the last cycle; continued strength in commodity prices argues for a more rapid reversal of recent policy...

However, John Hussman thinks that the strength in commodities -- key to the proponents of an inflation threat -- is not sustainable.

... I continue to view commodities as cyclical, and decoupling as implausible – indeed, my impression is that the commodity surge will likely be turned on its head within a few months, about the point where 10-year Treasury yields move above the year-over-year CPI inflation rate. Having spent the mid-1980's working at the Chicago Board of Trade, I was always impressed how much more “V-shaped” commodity price charts were than equities or bonds. Spike tops, spike bottoms, and steep reversals are common. Investors overly tied to the commodity boom and “global demand” as drivers of investment positions would do well to examine that behavior. It is often initially painful, but ultimately worthwhile to remember that it's best to panic before everyone else does.

Elevated US headline inflation proves persistent

The latest numbers on consumer prices in the United States indicate that inflation looks relatively contained, especially so-called core inflation excluding food and energy. However, the Federal Reserve's focus on core inflation over the past few years may actually have resulted in it leaving too much inflation on the table.

On 16 April, the US Labor Department reported that the consumer price index (CPI) rose 0.3 percent in March. This followed an unchanged reading in February. The energy index was a major contributor, rising 1.9 percent in March after declining 0.5 percent in February. Excluding food and energy, consumer prices rose 0.2 percent in March after having been unchanged in February.

Compared to the year-ago level, the headline CPI rose 4.0 percent in March, the same as in February. The so-called core CPI excluding food and energy rose 2.4 percent in March, up from 2.3 percent in February.

The Labor Department report shows that inflation, while no longer accelerating, remains somewhat elevated, with the CPI excluding food and energy even showing a slight uptick in the year-on-year rate of increase.

Other measures of core consumer price inflation monitored by the Federal Reserve Bank of Cleveland show even higher levels of core inflation than the traditional core index. The following table from the Cleveland Fed shows the recent monthly percentage changes in its 16-percent trimmed-mean CPI and median CPI in addition to the traditional CPI measures from the Labor Department.

	Oct	Nov	Dec	Jan	Feb	Mar
CPI	0.3	0.9	0.4	0.4	0.0	0.3
CPI less food & energy	0.2	0.2	0.2	0.3	0.0	0.2
16% trimmed-mean CPI	0.3	0.3	0.2	0.4	0.1	0.3
Median CPI	0.3	0.3	0.3	0.3	0.1	0.3

The next table, showing the percentage changes in these indicators over the last 12 months, makes it more apparent that headline inflation has been, and remains, higher than measures of core inflation, with inflation excluding food and energy showing the smallest rate of increase.

	Oct	Nov	Dec	Jan	Feb	Mar
CPI	3.5	4.3	4.1	4.3	4.0	4.0
CPI less food & energy	2.2	2.3	2.4	2.5	2.3	2.4
16% trimmed-mean CPI	2.7	2.8	2.8	3.0	2.8	2.8
Median CPI	3.0	3.1	3.1	3.2	3.0	3.0

Elsewhere, inflation showed varying trends. Among the other major developed economies releasing inflation figures last week, Canada reported a dip in inflation, consumer prices rising just 1.4 percent in March compared to a year ago, less than the 1.8 percent increase in the previous month. In the UK, the annual rate for March was unchanged from February at 2.5 percent. In the euro area, though, inflation accelerated, consumer prices jumping 1.0 percent in March to bring the annual inflation rate to 3.6 percent from 3.3 percent in February.

The diverging trends are reflected in the respective central bank stances. The European Central Bank (ECB) has continued to express concern about inflation, stubbornly resisting calls to cut interest rates, or even to move to an easing bias. In contrast, the Federal Reserve, the Bank of England and the Bank of Canada have all cut interest rates recently.

The contrast between the Federal Reserve and ECB actions so far is all the more remarkable when one considers that the reported headline inflation rate of 4.0 percent in the US remains above the 3.6 percent rate in the euro area.

However, we all know that the Federal Reserve focuses on the core inflation rate -- specifically, inflation excluding food and energy -- rather than the headline inflation rate, and the former has been consistently lower than the latter in recent years. The reason for the focus on the core rate is that Federal Reserve officials consider the headline number too volatile, often reflecting temporary supply shocks, and that the core rate better reflects the underlying inflation rate.

In contrast, the ECB does not explicitly monitor a core inflation rate as it does not assume that such a rate, especially one that specifically excludes food and energy, is necessarily a better reflection of the underlying inflation rate. Instead, it looks at a wide range of indicators to determine longer-term inflation trends.

Would the Federal Reserve be well-advised to de-emphasise the core inflation rate, specifically inflation excluding food and energy?

The headline CPI started to diverge in earnest from the measures of core CPI -- especially the CPI less food and energy -- from 2003 onwards. While the headline CPI has indeed been more volatile than the core indicators, it has fluctuated around a very apparent trend line, a line that clearly reflects a high trend rate of increase. In contrast, the most widely-used measure of core CPI in the US, the CPI less food and energy, has consistently shown the slowest rate of increase.

In other words, the elevated headline inflation has been persistent. With the prices of crude oil and other commodities continuing to rise in recent weeks, it is likely to remain so.

After five full years of divergence between the headline inflation rate and the inflation rate excluding food and energy, it must surely be time for the Federal Reserve to start to question whether the latter really is a better reflection of underlying inflation, as it has insisted, and whether the Federal Reserve might not be better off to emulate the ECB and just focus on headline inflation instead.

Strictly speaking, the Federal Reserve does not actually use the CPI as a gauge of inflation but rather the personal consumption expenditures (PCE) price index, but this fact provides no solace. PCE inflation excluding food and energy has also consistently lagged overall PCE inflation.

What has caused prices excluding food and energy to lag overall prices?

Many economists attribute this phenomenon to globalisation and the rapid industrialisation of emerging economies, especially China. On the one hand, the sharp rise in the supply of labour available from emerging economies has allowed manufactured goods to become cheaper, lowering the inflation rate of prices outside of food and energy. On the other hand, it has raised the prices of commodities such as food and oil, where the increase in demand has outstripped the increase in supply.

Therefore, insofar as the increasing availability of cheap manufactured goods and rising demand for commodities are the result of the reintegration of emerging economies like China into the global economy and may prove to be long-term trends, reliance by a central bank on an inflation rate that excludes just food and energy may result in the underlying inflation trend being underestimated and allow an unintended inflationary bias to be introduced into monetary policy.

Having said that, the focus on the inflation rate excluding food and energy does confer an advantage in inflation-fighting by focussing attention on a lower rate. This could help lower inflation expectations.

However, it also carries a risk. The continued focus on a so-called core rate in the presence of a persistently and obviously higher headline rate could damage the credibility of the Federal Reserve and be interpreted as a sign that it is unable or unwilling to accurately report and fight inflation. This would raise inflation expectations.

The risk of inflation expectations getting unanchored is one that the Federal Reserve may not be able to afford to ignore. With Federal Reserve officials already expressing commitment to combating downside risks to growth, it may not be able to withstand further assaults on its inflation-fighting credentials.

US Treasuries fall despite weak Philadelphia Fed index

Traders are betting that the end of Fed easing may be near. From Bloomberg:

Two-year notes dropped a fourth straight day, the longest slide since December, as Dallas Fed President Richard Fisher said he's hesitant to lower rates further...

Most traders are betting the Fed will cut its target rate by just a quarter-point to 2 percent on April 30. Futures on the Chicago Board of Trade show an 82 percent chance of that size reduction, up from 58 percent a week ago. The rest of the bets are on a half-point cut. Traders now see a better-than-even chance the rate will stay at 2 percent through year-end.

This is despite a weak April report for manufacturing in Philadelphia. From Bloomberg:

The Federal Reserve Bank of Philadelphia reported that its general economic index in April fell to minus 24.9, lower than economists had forecast...

But it was not all bad.

... The index measuring the manufacturing outlook for six months from now rose to 13.7 from minus 0.5.

Other data released yesterday showed that the US economy is weak but did not clearly point to a recession.

The Labor Department reported earlier today that initial claims for unemployment insurance increased by 17,000 to 372,000 in the week that ended April 12. The number of people on benefit rolls climbed to 2.98 million the previous week, the most since June 2004.

"These numbers are consistent with a soft labor market, maybe continued job losses, but not a big collapse in the economy," said Michael Darda, chief economist at MKM Partners in Greenwich, Connecticut, in an interview with Bloomberg Television.

The Conference Board's gauge increased 0.1 percent, as forecast, after falling 0.3 percent in February, the New York- based private research group said today...

"While latest data do not support the assertion that we are in a recession, growth remains weak, a situation that may continue," Ken Goldstein, a Conference Board economist, said in a statement.

China tightens, US still looking for rate cuts

China announced yet more tightening yesterday. Bloomberg reports:

China's economy grew 10.6 percent, faster than estimated, and inflation was close to the quickest in 11 years, prompting the government to order banks to set aside more money to slow lending.

Gross domestic product for the first quarter grew more than the 10.4 percent median estimate of 24 economists surveyed by Bloomberg News. Consumer prices climbed 8.3 percent in March, the statistics bureau said today in Beijing.

As the U.S. economy falters, policy makers in China, the biggest contributor to global growth, still regard inflation and overheating as bigger threats than a slowdown. The central bank raised the proportion of deposits that lenders must set aside as reserves to a record 16 percent to cool an economy that has grown more than 10 percent for nine straight quarters...

Reserve requirements will rise 50 basis points from April 25, the third increase this year, the People's Bank of China said today on its Web site. Within an hour of the announcement, Premier Wen Jiabao said in a statement that inflation is China's biggest problem.

Inflation is also a big concern in Europe, especially after the March rate turned out to be a little higher than previously estimated and boosted the view that the ECB is unlikely to cut rates soon.

European inflation accelerated more than initially estimated in March, reinforcing the European Central Bank's resistance to cutting interest rates even as economic growth cools.

The inflation rate rose to 3.6 percent last month, the highest in almost 16 years, the European Union's statistics office in Luxembourg said today. The March figure is up from 3.3 percent in February and exceeds an estimate of 3.5 percent published on March 31...

From the previous month, euro-area consumer prices rose 1 percent in March, according to today's report, a figure the EU's Torres called "quite high." The core rate of inflation, which excludes volatile food and energy costs, also was 1 percent from February. The core inflation rate was 2 percent from the year-earlier month, accelerating from 1.8 percent in February.

In contrast, the data from the US suggest that monetary easing will continue.

The U.S. housing implosion worsened in March, while manufacturing stabilized and a stagnant economy limited the ability of companies to pass higher food and energy costs on to consumers.

Work began on 947,000 homes at an annual rate, the fewest since March 1991, the Commerce Department said today in Washington. Industrial production gained 0.3 percent in the month, according to the Federal Reserve, and the Labor Department reported that consumer prices rose 0.3 percent, matching economists' forecasts...

"Economic conditions have weakened since the last report," the central bank said today in its regional business survey, known as the Beige Book for the color of its cover. "Nine Districts noted slowing in the pace of economic activity, while the remaining" three "described activity as mixed or steady."

The economic weakness is expected to remain the Fed's focus.

"Their primary focus has to be on the downside risk to growth," said Brian Bethune, director of financial economics at Global Insight Inc., in Lexington, Massachusetts. "There is very little ability for companies to pass on price increases."...

Economists surveyed by Bloomberg this month forecast the economy will not grow at all in the first half of the year, the weakest performance since the 2001 downturn.

Investors project the central bank will lower the benchmark rate by at least a quarter point later this month.

That's despite the fact that the 12-month inflation rate in the US remains higher than in Europe.

Prices rose 4 percent in the 12 months to March, the same as the year-over-year gain in February. The core rate increased 2.4 percent from March 2007, after a 2.3 percent year-over-year increase the prior month.

US turns less dovish, ECB reiterates hawkish stance

Opinion in the US appears to be shifting towards a less dovish stance on interest rates. From Bloomberg:

Most Federal Reserve banks, before the near-collapse of Bear Stearns Cos., favored a smaller reduction or no change at all in the charge for direct loans to banks than Fed governors approved last month.

Six of the 12 banks sought a half-point discount-rate cut before the March 14 announcement of emergency aid to Bear, while three asked for no change, according to minutes of Fed board meetings released today in Washington. The Fed board then lowered the rate by a quarter point on Sunday, March 16, and again by 0.75 percentage point at the regular meeting March 18.

The report may reinforce investor expectations that the Fed is unlikely to keep up this year's pace of interest-rate cuts, the fastest in two decades. Harvard University economist Martin Feldstein, an early advocate of aggressive rate reductions, called on the central bank today to halt the cuts.

Feldstein's views were detailed in a WSJ article.

It's time for the Federal Reserve to stop reducing the federal funds rate, because the likely benefit is small compared to the potential damage.

Lower interest rates could raise the already high prices of energy and food, which are already triggering riots in developing countries. In order to offset the inflationary impact of higher imported commodity prices, central banks in those countries may raise interest rates. Such contractionary policies would reduce real incomes and exacerbate political instability.

Similarly, Tim Duy argues that "given the increasingly clear link between monetary policy, the Dollar, and commodity prices, the Fed would be best to served to moderate the pace of easing".

And right on cue, yesterday's economic reports appear to justify such views. From Bloomberg:

U.S. producer prices rose almost twice as much as forecast and manufacturing in New York state unexpectedly grew, reducing the odds that the Federal Reserve will cut interest rates more than a quarter point this month.

Food and energy stoked the 1.1 percent gain in wholesale prices in March, the Labor Department reported today in Washington. The New York Fed's Empire State manufacturing index rose to 0.6 for April from minus 22.2, which was the lowest on record...

The National Association of Home Builders/Wells Fargo index of builder sentiment held at 20, the Washington-based group said today. The index reached a record low of 18 in December. Levels under 50 mean most respondents view conditions as poor.

In contrast to the Fed, the ECB doesn't need to be given such advice. From Bloomberg:

The European Central Bank signaled faster inflation will keep it from cutting interest rates even as investor confidence in Germany, Europe's largest economy, plunged.

ECB Executive Board member Juergen Stark said rates may not be high enough to contain inflation after French prices jumped 3.5 percent in March from a year earlier. Council member Nicholas Garganas said price pressure "is more intense than previously foreseen" and Miguel Angel Fernandez Ordonez said the ECB is "always more worried about inflation" than economic growth...

The ZEW Center for European Economic Research in Mannheim said today its index of German investor and analyst expectations declined to minus 40.7 from minus 32 in March. Economists expected a gain to minus 30.

Among the major central banks, the BoE remains the most likely to follow in the Fed's rate-cutting path after inflation in the UK held steady at 2.5 percent in March amid signs of a deteriorating economy as like-for-like retail sales fell in March and the RICS survey showed the most widespread fall in house prices last month in its 30-year history.

US retail sales rise even as pessimism increases

The US economy may be falling into recession but US retail sales on the whole did not fall in March, at least in nominal terms. Bloomberg reports:

Retail sales rose 0.2 percent, the Commerce Department said today in Washington. Economists surveyed by Bloomberg News had forecast no change. The figures also showed purchases excluding gas were unchanged. Companies' stocks of unsold goods rose 0.6 percent in February as sales dropped, a separate report showed.

Nevertheless, some retailers are pessimistic.

Some retailers aren't counting on a quick end to the U.S. economic slump.

"I don't think we're very optimistic about it ending anytime soon," J.C. Penney Co. Chief Executive Officer Myron Ullman said last week at the World Retail Congress in Barcelona. He reiterated that J.C. Penney plans to open 36 stores this year, down from an original plan of 50.

Economists and CEOs are pessimistic too.

The odds the economy will be in a recession in the next 12 months jumped to 70 percent in April from 50 percent in March, according to a monthly survey of economists by Bloomberg...

Chief executive officers last quarter grew more pessimistic about the economy, according to a report today from the New York- based Conference Board. The private research group's CEO index fell to 38, the lowest level in seven years, compared with 39 the previous three months. Readings less than 50 indicate more pessimistic than optimistic responses.

The good news for the US economy is that firms are relatively cash-rich. Bloomberg reports:

The U.S. economy has what Alan Greenspan calls one "major advantage" as it falls into a recession: Businesses are in far better financial shape than they were entering the past two contractions.

Corporations outside of financial services -- from Cisco Systems Inc. to Coca-Cola Co. -- have collectively socked away more than half a trillion dollars in cash. They have also reduced short-term debt and cut inventories to near record-low levels in relation to sales, leaving them better prepared than in the past to weather a contraction.

"We still have what, at the moment at least, appears to be a reasonably good real economy, as distinct from finance," the former Federal Reserve chairman said at an April 8 conference sponsored by Deutsche Bank AG and co-hosted by Bloomberg.

The current Fed chief, Ben S. Bernanke, sees it much the same. On April 2, he told lawmakers that aside from the banking and securities industries, corporate balance sheets are sound -- a "positive" for the economy...

The cash hoards mean companies aren't so dependent on battered banks for money to finance their operations. Debt as a percentage of net worth for non-financial companies outside of farming was 61.3 in the fourth quarter of last year, compared with 68 at the start of the 2001 recession and 93.6 in the 1990- 91 contraction, Fed figures show.

However, there is a dark side to firms' growing cash pile. Firms have more cash largely because they took it from households, their end customers. If their end customers are forced to reduce spending as a result, then, as JC Penny shows, firms could cut back too.

Singapore dollar jumps as the MAS tries to get ahead of the curve

Last week, the Singapore dollar posted its biggest weekly gain against the United States dollar in almost a decade after the country's central bank announced that it was raising the band within which the currency was allowed to trade in what looks like a determined attempt to rein in inflation.

The Singapore dollar rose 1.9 percent against the US dollar last week. It finished the week at S$1.3586 per US dollar after touching a record high of S$1.3553. It also rose over one percent against both the euro and the Japanese yen.

The decision by the Monetary Authority of Singapore (MAS) represents an attempt by the central bank to bring under control an inflation rate that has been accelerating to multi-decade highs over the past year in a country where inflation had been almost non-existent over the previous ten years.

Just last month, the International Monetary Fund (IMF) had released to the public its country report on Singapore which had been completed on 15 June 2007. The report looked into various aspects of the Singapore economy, including its monetary policy.

The report noted that the monetary policy stance had been kept on a tightening bias since April 2004, targeting a modest and gradual appreciation of the Singapore dollar. The authors noted that "Singapore’s monetary policy framework centered on the management of the exchange rate has served the economy well, keeping inflation low in support of impressive growth" and with "inflation expectations well anchored, there is no compelling reason to change the current monetary policy stance".

Subsequent developments were to show that they spoke too soon.

However, at the time the report was written, inflation in Singapore was indeed low. In fact, it had been low for the past ten years. From 1996 to 2006, the consumer price index (CPI) had risen at an average annual rate of just 0.7 percent.

Then in April 2004, after the CPI had risen just 0.5 percent the previous year, the MAS nevertheless shifted policy from a zero percent appreciation path to a policy of modest and gradual appreciation of the Singapore dollar.

This move proved prescient. The inflation rate picked up to 1.7 percent in 2004, the highest rate since 1997, but fell back to 0.5 percent in 2005.

At that point, MAS policy-makers looked like maestros. Even the IMF could not find much wrong with monetary policy in Singapore.

However, central bank maestros tend to shed their reputations rather quickly nowadays.

From the middle of 2007, Singapore's inflation rate started to accelerate. That year, consumer prices rose 2.1 percent, accelerating especially in the latter half of the year. Then in January 2008, consumer price inflation hit 6.6 percent on a year-on-year basis, the highest rate since 1982, before pulling back a little to 6.5 percent in February.

Part of the reason for the increase in the rate of consumer price inflation was an increase in the goods and services tax by two percentage points in July 2007 from 5 percent to 7 percent. However, this only accounts for a relatively small portion of the increase in the inflation rate.

The more important reason is that the Singapore economy was overheating.

Over the past four years, the economy has grown by at least 7 percent in each and every year for an average annual rate of 8 percent. This is above the 4-6 percent range that the Singapore government considers to be the economy's underlying potential growth rate.

With the high rate of growth, the labour market has tightened. The unemployment rate fell to just 1.6 percent at the end of 2007, one of the lowest in the world.

Macroeconomic policy in Singapore had become too expansionary. The economy grew too rapidly, putting pressure on domestic resources and resulting in rising prices.

Rising inflation, however, has been a global phenomenon. Expansionary policies pursued by many countries have raised inflation rates all around the world -- from emerging economies like China to rich economies like the US and even to deflation-prone economies like Japan. While the MAS has allowed the Singapore dollar to appreciate in the past few years, it has not done so to a degree sufficient to shield the Singapore economy from global inflationary pressures.

Corrective action was attempted in October 2007 when the MAS raised the rate of appreciation of the Singapore dollar in an attempt to tighten monetary conditions. The continued rise in the inflation rate subsequently must have convinced the MAS that it was not enough.

So on 10 April, the MAS decided to tighten again, this time by raising the band within which it allows the currency to fluctuate. This was tantamount to a revaluation and, as Joseph Tan of Fortis Bank pointed out to CNBC on the day of the decision, is a signal that the MAS has fallen behind the curve.

A rebound in Singapore's economy in the first quarter probably emboldened the MAS in making the move. On the same day as the MAS announcement of the tightening, the Ministry of Trade and Industry reported that its advance estimates show that Singapore's real gross domestic product expanded by 16.9 percent in the first quarter on a quarter-on-quarter seasonally-adjusted annualised basis after having declined by 4.8 percent in the previous quarter.

In the policy statement released to announce its decision, the MAS noted that inflation was being driven from both external and domestic sources. The former includes elevated global oil and food prices. Domestic inflationary pressures came from capacity constraints in certain segments of the economy.

According to its statement, the MAS expects inflation to moderate in the second half of the year. For 2008 as a whole, it projects CPI inflation to come in at the upper half of the 4.5-5.5 percent forecast range.

The MAS probably cannot afford to take its eye off the ball any more. Even if the inflation rate falls to the bottom end of its projected range, it would still be substantially above the yields on government securities, which today range from just above 3 percent at the long end to below 1 percent at the short end.

Prolonged negative real interest rates cannot form a sound basis for economic growth.

US consumer confidence falls, inflation may not

US consumer confidence fell in April. Bloomberg reports:

Confidence among U.S. consumers fell to a 26-year low after employers fired workers and gasoline prices surged, threatening the spending that accounts for more than two thirds of the economy.

The Reuters/University of Michigan preliminary index of consumer sentiment decreased to 63.2 this month, the weakest level since 1982, when the jobless rate approached 11 percent, the worst since the Great Depression...

The fall in consumer confidence comes as inflation expectations are rising.

Consumers polled in today's survey said they expect an inflation rate of 4.8 percent in a year, compared with 4.3 percent projected last month.

There are good reasons for the rise in inflation expectations.

In other figures released today, the Labor Department reported that the cost of imported goods climbed 14.8 percent in March from a year ago, led by oil...

Import prices rose 2.8 percent in March after a 0.2 percent gain the prior month, the Labor Department said. Expenses excluding fuels jumped 0.9 percent, the most since records began in 2001.

It is a similar situation in Japan. From AFP/CNA:

Japan's wholesale inflation rate hit a fresh 27-year high of 3.9 per cent in March as companies struggled to cope with soaring raw material and energy costs, a report from the central bank showed.

Producer price inflation accelerated from a revised annual rate of 3.6 per cent in February, the Bank of Japan said. It was the strongest rise in corporate goods prices since February 1981.

Inflation could hang around for quite a while longer, according to an ECB official. From Bloomberg:

European Central Bank council member Axel Weber said he doesn't see any scope to cut interest rates with inflation running at the fastest pace in almost 16 years...

"I fear that current inflation rates will remain for most of the year," Weber said. "It's important that there aren't any new inflationary pressures. We won't tolerate broad price pressures."

Morgan Stanley's Joachim Fels and Manoj Pradhan probably aren't surprised by all this inflation. They say that monetary policy in most of the major economies, including the euro area, are expansionary.

In the US, the Fed’s 200bp of rate cuts in 1Q have taken the actual fed funds rate way below the natural rate... Thus, US monetary policy is now firmly back in expansionary territory, as it was for most of this decade with the exception of 2000 and 2006-07...

In the euro area, our estimates also suggest that monetary policy is expansionary, though only moderately so... It should hardly come as a surprise then that inflation in the euro area is running significantly above the ECB’s comfort level...

[We] conclude that monetary policy in the three largest EM economies (China, India and Russia...) appears to be very expansionary at this stage... Against this backdrop, we reiterate our long-held view that inflation expectations are too low and investors would be well advised to buy protection against higher inflation.

Meanwhile, China's monetary policy may be expansionary but its trade surplus shrank 10 percent in the first quarter from a year ago despite a rebound in March.

The US trade balance hasn't benefited as a result. On Thursday, the Commerce Department had reported that the trade deficit widened 5.7 percent in February despite a fall in the deficit with China and a fall in the import of crude oil.

BoE cuts rates, other central banks focus on inflation

The BoE cut interest rates yesterday. Reuters reports:

The Bank of England cut interest rates for the third time in five months on Thursday to cushion the economy from the global credit squeeze, despite persistent worries about rising inflation.

The central bank said the quarter-percentage point reduction in its main rate to 5.0 percent was justified even though inflation was likely to spike this year.

"Credit conditions have tightened and the availability of credit appears to be worsening," the BoE said in a statement.

"The disruption in financial markets could lead to a slowdown in the economy that was sufficiently sharp to pull inflation below target."

The cut was not surprising. Although industrial output had grown at a better-than-expected rate of 0.3 percent in February, economic growth probably slowed in the first quarter and consumer confidence fell in March to its lowest levels in four years.

However, the BoE proved to be the odd man out yesterday. The ECB held firm, as Bloomberg reports:

European Central Bank President Jean- Claude Trichet signaled he's still not ready to cut interest rates even as the credit squeeze poses a greater threat to economic growth than policy makers anticipated.

"We are experiencing a rather protracted period of temporarily high annual rates of inflation," Trichet said at a press conference in Frankfurt today after the ECB kept its key rate at 4 percent. While financial-market tension may have "a broader than currently expected impact on the real economy," ensuring price stability is "very serious for us," he said.

And many central banks are still in tightening mode. For example, Iceland's. From Bloomberg:

Iceland's central bank raised its benchmark interest rate for the second time in three weeks, pushing it to the highest in Europe to shore up the krona and damp inflation that is running at three times the target.

The key rate was raised by a half point to 15.5 percent, the Reykjavik-based central bank said on its Web site today. Five of nine economists surveyed by Bloomberg had expected rates to be left on hold, while four forecast an increase.

Bloomberg also reports a similar move by the South African Reserve Bank.

South Africa's central bank raised its benchmark interest rate by a half point, the fifth increase in 10 months, forecasting that rising energy costs would keep inflation outside the target range until the end of next year.

The Monetary Policy Committee increased the repurchase rate to 11.5 percent, Governor Tito Mboweni said in a televised speech from Pretoria today. That was in line with the forecast of 13 of 27 economists surveyed by Bloomberg. The rest predicted no change.

And by Peru's central bank:

Peru's central bank today unexpectedly raised its benchmark lending rate to 5.50 percent in a bid to control the steepest inflation since 1999.

The earliest move yesterday, though, had come from Singapore. Bloomberg reports:

... The Monetary Authority of Singapore, which uses the exchange rate instead of interest rates to manage the export- driven economy, said it made an "upward shift" to the undisclosed limits within which it lets the currency fluctuate...

"An upward shift of the policy band will help to moderate inflation going forward while providing for sustainable growth in the economy," the central bank said in its twice-yearly review. "Inflation is expected to remain high until the middle of the year before easing in the second half." Previously, the central bank targeted "modest" appreciation of the currency.

The move came after a surprisingly strong rebound in economic growth in the first quarter.

The city-state's economy grew an annualized 16.9 percent in the three months ended March, after shrinking 4.8 percent in the previous quarter, the trade ministry said in a statement today. Economists were expecting a 10.2 percent gain, according to a Bloomberg survey.

The MAS move not only pushed the Singapore dollar higher yesterday but helped drive up other Asian currencies as well.

Singapore's policy shift helped drive the Chinese yuan to beyond 7 per dollar and the Malaysian ringgit to a decade-high on speculation Asian central banks will seek stronger currencies to reduce record costs for importing rice, wheat and fuel.

Singapore's dollar rose to a record S$1.3553 against the U.S. dollar, before trading at S$1.3583 by 5:18 p.m. in London, the largest daily gain since Oct. 7, 1998. The currency has gained 5.7 percent this year and is the second-best performer in the region outside of Japan.

BoJ holds interest rates, cuts economic assessment

Yesterday, we had a new Bank of Japan governor but no change in interest rates as he acknowledged a slowing Japanese economy. Bloomberg reports:

The Bank of Japan's new Governor Masaaki Shirakawa said growth will keep slowing as rising oil and commodity prices weigh on the world's second-largest economy.

"Higher energy and raw-materials costs are causing the economy to slow now," Shirakawa, 58, told reporters in Tokyo today after the bank cut its economic assessment for the first time in four months and kept the key interest rate at 0.5 percent. "The mechanism of production, income and spending is weakening, but it's not as if it's fallen apart."

Reports earlier in the week had not been too bad, though. On Monday, Bloomberg had reported:

The leading index, derived from 12 indicators including housing starts and stock prices, rose to 50 percent in February, matching the threshold that signals growth will continue over the next two quarters, the Cabinet Office said today in Tokyo. The index has been below 50 in eight of the past 12 months.

Japan will probably weather the U.S. slowdown and keep expanding through 2009, the Organization for Economic Development and Cooperation said today. Exports to Asia have helped the economy maintain its footing amid financial-market turmoil and the worst U.S. housing recession in a generation...

The world's second-largest economy will expand 1.6 percent this year, the OECD said, keeping its forecast unchanged from December. Japan grew 2.1 percent last year.

On Tuesday, Bloomberg reported:

The Economy Watchers index, a survey of barbers, taxi drivers and others who deal with consumers, rose to 36.9 from 33.6 in February, the Cabinet Office said today in Tokyo. The outlook index of conditions in two to three months fell to 38.2.

There were more positive reports from Bloomberg today. For example, the current account surplus widened in February.

The surplus expanded 2.9 percent to 2.47 trillion yen ($24 billion) from a year earlier, the Ministry of Finance said in Tokyo today. The median estimate of 24 economists surveyed by Bloomberg News was for the gap to increase to 2.47 trillion yen...

Export rose 9 percent in February from a year earlier, accelerating from 8.4 percent in January, today's report showed. Imports increased 12.5 percent, compared with a 9.1 percent gain in January.

Loan growth accelerated in March.

Japan's bank lending accelerated for the third straight month in March as companies borrowed more to pay for higher-priced raw materials and as spreads on corporate bonds rose, making bank loans more attractive.

Loans excluding trusts rose 1.2 percent from a year earlier, the most since February 2007, after growing 0.9 percent in February, the Bank of Japan said today. Bank lending has climbed for 26 months, peaking in July 2006 when the Bank of Japan ended a policy of keeping interest rates near zero.

But machinery orders fell in February.

Japanese machine orders fell in February as companies scaled back investment plans on concern a U.S. recession may hurt overseas sales.

Equipment orders, which signal capital spending in the next three to six months, declined 12.7 percent from January when they climbed 19.6 percent, the Cabinet Office said today in Tokyo. The median estimate of 30 economists surveyed by Bloomberg News was for a 14 percent drop.

House prices falling, Greenspan's reputation not far behind

While some semblance of calmness has been restored to financial markets in recent weeks, there is still risk of more turmoil ahead.

For one, weakness in housing has clearly spread to the UK. Reuters reports:

House prices fell 2.5 percent during last month, the Halifax said, more than six times as much as analysts had forecast and the largest monthly decline since September 1992.

Meanwhile, the US housing market continued to deteriorate in February. Bloomberg reports:

The number of Americans signing contracts to buy previously owned homes declined more than forecast in February, indicating no sign of a bottom in the U.S. real-estate recession that is entering its third year.

The National Association of Realtors' index of signed purchase agreements decreased 1.9 percent to 84.6, the lowest reading since records began in 2001, the group said today. The drop follows a revised 0.3 percent increase in January.

If these trends are sustained for much longer, the recent IMF estimate of losses could start to look conservative. From Bloomberg:

The International Monetary Fund said losses stemming from the U.S. mortgage crisis may approach $1 trillion, citing a "collective failure" to predict the breadth of the crisis.

Falling U.S. house prices and rising delinquencies may lead to $565 billion in residential mortgage-market losses, the IMF said in its annual Global Financial Stability report, released today in Washington. Total losses, including those tied to commercial real estate, may reach $945 billion, the fund said. The fund also saw as much as $90 billion in further losses from potential downgrades of bond insurance companies.

On the other hand, a famous ex-central bank chief is looking for an end to the deterioration in the housing market. From Bloomberg:

Former Federal Reserve Chairman Alan Greenspan said the drop in U.S. home prices will probably end "well before" early next year as the number of houses on the market diminishes, aiding an economic rebound.

"It will not be until early 2009 that we will get close to having eliminated most of this" home inventory, Greenspan told a conference in Tokyo today sponsored by Deutsche Bank AG and co-hosted by Bloomberg LP. "But it is very likely that home prices will stabilize well before that."

Not that he thinks there won't be pain along the way.

Greenspan said today that "the current credit crisis is the most wrenching in the last half century and possibly more." He added in [a] CNBC interview that while the economy was "in the throes of a recession," the non-financial part of the economy is in "good shape."

But Greenspan's views may not be held in the same esteem as they once were.

Greenspan, who retired in 2006 after 18 years as the U.S. central-bank chief, has come under increasing criticism for his policies as last year's subprime-loan meltdown spread into a broader financial crisis. One recent book, "Greenspan's Bubbles" by money manager William Fleckenstein, argues the former Fed chief helped inflate stock and home prices...

Yesterday, in a Financial Times piece headlined "The Fed is blameless on the property bubble," Greenspan wrote that the evidence is "very fragile" that Fed interest-rate policy added to the U.S. bubble and that "it is not credible that regulators would have been able to prevent the subprime debacle."

For more on the debate over Greenspan's role in the housing bubble, see this post at the Economists' Forum as well as Willem Buiter's extended critique.

Greg Ip also has a WSJ article on criticisms of Greenspan. However, this article appears slanted to favour Greenspan because, as Dean Baker points out, it "focuses on the views of the critics who only recognized Greenspan's failings in retrospect", making it easier to dismiss those criticisms.

Analysts slow to cut earnings and economic forecasts

Analysts have been too slow in cutting earnings forecasts for US companies, according to this Bloomberg story.

When Wall Street's almost 1,800 equity analysts figured U.S. earnings growth for the third quarter of 2007, they were 8.2 percentage points too high. Forecasts for the fourth quarter were wrong, too, overestimating profits by 33.5 percentage points, the biggest miss ever.

It's no wonder investors don't trust analysts, says Liz Ann Sonders, chief investment strategist at Charles Schwab Corp., which oversees $1.4 trillion for clients. Merrill Lynch & Co., Bank of America Corp. and the rest of the securities industry aren't losing credibility because of anything sinister. The problem is they didn't get their math right after credit markets froze nine months ago.

As Alcoa Inc. kicks off first-quarter earnings season today, analysts say 2008 will be the best year ever for U.S. profits, data compiled by Bloomberg show. Earnings for companies in the Standard & Poor's 500 Index will rise 10.7 percent, even after Federal Reserve Chairman Ben S. Bernanke acknowledged that the economy may fall into a recession and banks reported $232 billion of writedowns and losses, the forecasts show.

The analysts are "going to lead you off the cliff," said Richard Weiss, 47, who oversees $60 billion as chief investment officer at City National Bank in Beverly Hills, California. First-quarter earnings will be "a big wake-up call for some analysts who are sitting on big double-digit numbers," he said.

John Mauldin has also reproduced an article from James Montier that says that analysts are "asleep at the wheel", with their earnings forecasts lagging reality, but that this is not unusual.

Meanwhile, Menzie Chinn shows us that growth forecasts for the US and several other economies have also been drifting down gradually over the past few months. He notes:

One source of comfort -- no negative growth forecasted! (Of course, the low values for each forecast of y/y growth are now consistent with two quarters of negative growth.)

Japan looking like the US, US looking like Japan

The bad news from last week's economic reports is that the United States economy may already be falling into recession. To make things worse, the Japanese economy may be doing the same too. And the similarity between the two may not end there.

However, before we get to the last point, let's look at the latest economic indicators.

The Labor Department reported on Friday that US non-farm payrolls shrank by 80,000 in March. Based on the establishment survey, this was the third consecutive month that the economy has lost jobs and the biggest decline since March 2003.

According to the household survey, employment fell by 24,000 in March and the unemployment rate rose to 5.1 percent, the highest level since September 2005.

With the latest decline, employment in the US in March was barely higher than a year ago according to the establishment survey. Indeed, based on the household survey, the level of employment in March was actually lower than a year ago.

So it is beginning to look like the US economy will see a contraction in the first quarter. The deterioration of the labour market in the US is showing no sign of let-up. This is typically how recessions begin.

A recession in housing has already been on-going for some time, but last week provided further evidence that weakness in construction spending is spreading beyond housing. Spending on commercial construction declined 0.1 percent in February from the previous month, contributing negatively to a 0.3 percent decline in overall construction spending.

And weakness has also spread to manufacturing. On Wednesday, the Commerce Department reported that factory orders fell by 1.3 percent in February. This followed a 2.3 percent decline in January.

The reports from the Institute for Supply Management (ISM) last week also pointed to weakness in the economy. The manufacturing index came in at 48.6 in March, slightly up from 48.3 in February but staying below 50, indicating a contraction. The non-manufacturing index also saw a similar bounce to 49.6 in March from 49.3 in February but also stayed below 50.

The purchasing managers' indices generally held up in other major economies in the world. One notable exception was Japan's.

Manufacturing PMIs:

	February	March
US	48.3	48.6
Euro area	52.3	52.0
UK	51.3	51.3
Japan	50.8	49.5
China	52.8	54.4

The manufacturing PMI for Japan dropped below 50 in March, indicating contraction. This indication was corroborated by a report from the Ministry of Economy, Trade and Industry last week that showed that Japanese industrial production fell 1.2 percent in February, the second month of decline after output had fallen by 2.2 percent in January.

This has ominous implications for the Japanese economy. Historically, changes in Japanese gross domestic product closely match changes in Japanese industrial production. So there is a very real possibility of the Japanese economy accompanying the US economy into negative growth in the first quarter.

This means there is a risk that the global economy may be hit by a double whammy of recessions in both the US and Japan at the same time.

Beyond the possibility of a simultaneous dip into recession, the more intriguing comparison between the US and Japan for many observers has been whether the US could be following Japan's deflationary path of the 1990s. In the wake of the recent disruption in credit markets, there is fear that deleveraging among financial institutions in the US could lead to credit contraction and a similar deflationary outcome.

One of the oft-cited objections to the likelihood of deflation in the US is that its economy is currently experiencing elevated inflation, the opposite of deflation. While consumer price inflation did threaten to go into negative territory in 2002, determined easing of monetary policy by the Federal Reserve reversed that trend. Since then, inflation has surged back up and is now just over 4 percent.

A look back at the Japanese experience from about two decades ago provides us with an illuminating comparison.

In the mid-1980s, Japan had also experienced disinflation, with consumer price inflation actually dipping into negative territory around 1986-1987. Easier monetary policy from the Bank of Japan eventually reversed that trend. Inflation then turned around so much that it surged and peaked at 4 percent in late 1990 and early 1991, roughly at the same time as the peak in land prices and about one year after the peak in the stock market.

In other words, immediately at the end of its asset bubbles, "deflationary Japan" actually saw inflation levels almost as high as "inflationary US" is seeing today. It was only from the mid-1990s onwards that deflation became a persistent feature in Japan.

Obviously, there are many other factors that will determine the future path of the US economy. The above comparison does not mean that deflation is necessarily imminent in the US.

Nevertheless, if Japan taught us anything, it is that today's inflation does not confer an economy immunity from tomorrow's deflation. In fact, it may be a precursor to deflation.

US economy loses 80,000 jobs in March

US employment fell again in March. MarketWatch reports:

Nonfarm payrolls fell by an estimated 80,000 in March, the Labor Department said. It marked the largest decline seen since March 2003, underscoring how reluctant employers remain to committing to making new hires...

The nation's unemployment rate surged to 5.1% last month, the highest since September 2005...

Adding to the sense of weakness in employment, payrolls in January and February were revised lower by a cumulative 67,000.

Job losses thus have totaled 232,000 so far this year, an average of 77,000 lost jobs per month.

The government's separate household survey showed a decline in employment of 24,000 in March, and a 434,000 rise in unemployment. As a result, the unemployment rate rose.

The reaction in the stock market by the end of the day was muted, attesting to the relatively buoyant mood among investors recently. Again from MarketWatch:

After volatile moves in a 100-point trading range, the Dow Jones Industrial Average closed down 16.61 points to 12,609.42, giving it a weekly gain of 3.2%...

The S&P 500 gained 1.09 points, to 1,370.40, giving it a 4.2% rise from where it stood one week ago...

The Nasdaq Composite climbed 7.68 points to 2,370.98, up 4.9% from where the tech-heavy index stood at Friday's close one week ago.

The move in Treasuries was less ambiguous. From Bloomberg:

Treasuries rose, with 10-year notes gaining the most in two weeks, after a government report showed the economy lost more jobs last month than forecast and wages grew at the slowest pace in almost two years...

The yield on the benchmark 10-year note fell 13 basis points, or 0.13 percentage point, to 3.47 percent at 5:15 p.m. in New York, according to bond broker Cantor Fitzgerald LP...

The rally in longer-term debt pushed the yields on 10-year notes to within 164 basis points of two-year securities, which fell 7 basis points to 1.81 percent. The so-called yield curve is the narrowest since Feb. 6...

Traders now see a 40 percent chance the Federal Reserve will lower its target rate for overnight lending between banks a half-percentage point to 1.75 percent at their next scheduled meeting on April 30, up from 20 percent yesterday. The rest of the bets were on a quarter-point reduction, according to interest-rate futures on the Chicago Board of Trade...

Bonds still posted a weekly loss...

Notes maturing in two years rose 17 basis points this week, the most since the five days ended Dec. 14. Ten-year note yields rose 2 basis points.

Global growth weak but holding up

Yesterday's data show that economic growth is weak in the US and slowing in Europe.

In the US, the Institute for Supply Management's non-manufacturing index came in at 49.6 in March, below 50 but up from 49.3 in February. Earlier, the Labor Department reported that first-time unemployment benefit claims rose to 407,000 last week.

In the euro area, the Royal Bank of Scotland's service sector index fell to 51.6 in March from 52.3 in February while retail sales fell 0.5 percent in February.

In the UK, the Chartered Institute of Purchasing and Supply/NTC service activity index fell to 52.1 in March from 54.0 in February while a Bank of England survey showed that credit conditions are tightening.

On the whole, though, the global economy has so far not performed as badly as some had feared. From Reuters:

The Global Total Output index, produced by JP Morgan with research and supply management organisations, rose slightly to 51.8 in March from 51.7 in February, above the 50 mark that divides growth from contraction.

The index remained well above the low of 47.7 recorded at the start of 2008.

US factory orders fall, economy could contract

Yesterday's US data were mixed. Bloomberg reports that factory orders fell more than expected in February.

Orders to U.S. factories fell more than forecast in February, as companies scaled back investment plans on concern the economy was already in a recession.

The 1.3 percent decrease followed a 2.3 percent decline in January, the Commerce Department said today in Washington. Excluding orders for transportation equipment, which tend to be volatile, demand fell 1.8 percent, the largest decline since January 2007...

Orders for durable goods, which comprise about half of factory orders, fell 1.1 percent in February, led by the biggest slump in demand for machinery in four years, Commerce said.

Bookings for non-defense capital goods excluding aircraft, a proxy for future business investment, fell 2.4 percent...

But employment appears to be holding up better than expected.

Separately, a private survey from ADP Employer Services today showed companies unexpectedly added workers in March. The increase of 8,000 jobs followed a revised drop of 18,000 the prior month that was less than previously estimated, according to the report from ADP Employer Services.

Nevertheless, US economic growth is likely to be weak.

Federal Reserve Chairman Ben S. Bernanke, testifying before Congress today, acknowledged for the first time that the economy may contract as homebuilding weakens further, unemployment rises and consumer spending slumps. "It now appears likely that real gross domestic product will not grow much, if at all, over the first half of 2008 and could even contract slightly," Bernanke said in testimony to the Joint Economic Committee.

Stocks jump, manufacturing slips

Investors dived back into stocks in a big way at the start of the second quarter.

In the US, the S&P 500 added 3.6 percent after Lehman Brothers announced that it was raising $4 billion from a stock sale.

In Europe, the Dow Jones Stoxx 600 Index added 3.3 percent despite announcements of an additional $19 billion in write-downs from UBS and 2.5 billion euros from Deutsche Bank.

Asian stock markets mostly rose yesterday, with the Nikkei 225 gaining 1 percent. The China market, though, diverged rather spectacularly, the CSI 300 plunging 5.5 percent.

The generally ebullient mood of stock investors yesterday could mean that they have discounted much of the write-downs from banks, as David Gaffen and Chad Brand suggest. Gaffen, however, also points out that previous rallies on the back of announced write-downs could not be sustained.

Felix Salmon calls the rally "unreal" and suggests not to read too much into it.

The performance of stocks yesterday probably did not reflect yesterday's economic reports, which had been mixed, although some did turn out better than expected.

Global manufacturing growth slowed in March, with the JP Morgan Global Manufacturing PMI falling to 50.8 from 51.1 in February.

US manufacturing continued to contract in March, but the ISM manufacturing index rose to 48.6 from 48.3 in February. However, the new orders index fell to 46.5 from 49.1 while the prices index went in the other direction, rising to 83.5 from 75.5.

Elsewhere, apart from Japan, where the manufacturing PMI had slipped below 50, manufacturing activity generally held up relatively well. The PMI readings in the euro area, the UK and India all stayed above 50, while in China, two measures of manufacturing activity both showed large increases.

The resilience of the rest of the global economy helped push the German unemployment rate down to 7.8 percent in March, the lowest level since August 1992, from 8 percent in February. The eurozone unemployment rate had remained at a record low of 7.1 percent in February.

The resilience of the global economy, though, could be put to the test in coming months, as reports yesterday showed that the weakness of the US economy is persisting and hurting construction spending and auto sales.