Thursday, August 23, 2007

The latest from RBC about Financial market stress

Here is the latest from RBC about Financial market stress — not economic fundamentals — to prompt Fed rate cut as of August 22, 2007

We have revised our outlook for the Fed funds rate and are now calling for a 50 basis-point rate cut as policymakers work to alleviate liquidity concerns that have recently emerged in financial markets.

On August 17, the U.S. Federal Reserve reduced the discount rate in order to “promote the restoration of orderly conditions in financial markets.” The Fed has also updated its economic outlook, stating that “although recent data suggest that the economy has continued to expand at a moderate pace” volatility in financial markets has “the potential to restrain economic growth going forward.”

Since these risks have not yet abated, we expect the Fed to cut the Fed funds rate to 4.75% at or before the September 18 FOMC meeting, supplemented by other liquidity-enhancing measures, including possible additional changes to the discount rate and the continued injection of temporary reserves, until financing markets stabilize. The Fed is likely to keep the amount of easing limited, however, since the aim of this policy change is to ensure that financing remains accessible.

These Fed measures would also limit the extent of any damage to economic activity going forward. The combination of weaker equity markets and tightening credit conditions implies slightly greater restraint on business investment in the near-term. However, the extent of the restraint will be limited by large cash balances retained by businesses. The weakness in housing is likely to persist longer than previously expected.

Consumers will be contending with both falling housing prices and weaker equity prices that will likely moderate real spending growth to a pace slightly below 2.5% during the second half of this year. One main offset is that strong global demand will keep U.S. exporters in good shape. With import growth lagging, the trade sector will provide decent support to growth.

Inflation risks remain, making Fed reluctant to prime the system further
This growth outlook will not prevent core inflation from holding just above 2% for the remainder of 2007 and the headline CPI rate is expected to move higher as the big decline in commodity prices in the latter part of 2006 will likely not be repeated. Pipeline price pressures remain as evidenced by the elevated level of the ISM price indices and one-year inflation expectations are holding above 3% according to the University of Michigan consumer sentiment survey.

While the Fed has acknowledged that the “downside risks to growth have increased appreciably,” they were mum on the repercussions for the inflation outlook, suggesting that they still view the risks that “inflation will fail to moderate as expected” as remaining substantive.

Rate decline in 2007 will be more than reversed in 2008
Our baseline assessment for growth going forward is that the combination of tight labour markets, an easing in credit conditions and a return to stability in equity markets will limit the downside risk. While the financial market fallout may curb growth in the second half of 2007, more stimulative monetary policy in the near-term makes us confident in our 2.9% real GDP forecast for 2008. Importantly, a more stimulative monetary policy will keep alive the risks that core inflation will remain above 2% meaning that the Fed will look to reverse the rate cut.

By the second quarter of 2008, the period of risk reassessment and high liquidity needs is expected to have passed and the Federal Reserve will be looking to reverse the easing of mid-2007. Given our view that the economy will expand at about its potential pace in 2008 and that core inflation measures will remain above 2%, we expect the Fed to shift policy to a less neutral stance, with 75 basis points of rate increases expected by the end of 2008 to put the Fed funds rate at 5.5%, just a notch below our previous 5.75% year-end 2008 forecast.

Our revised Fed forecast calls for market interest rates to be lower in 2007 than in our previous outlook. We are forecasting the yield on the two-year UST at 4.5% at the end of 2007 with the 10-year yield forecast at 4.85%. This compares to our previous forecast which looked for the two-year yield to rise to 5.20% and 10-year rate to 5.35% at the end of 2007. Our forecasts for 2008 are little changed with the two-year at 5.55% and the 10-year rate at 5.75% at the end of the year.

Bank of Canada to stay on the sidelines; focus shifts to liquidity measures

Canada’s economy remains in healthy shape with second-quarter real GDP growth of 3% expected to be announced on August 31, the second consecutive quarter of above-potential growth. The retail spending report for June highlighted the economy’s strength with real retail sales growing at a stellar 10.7% annualized pace in the second quarter. Labour market conditions are tight and wage growth has accelerated sharply in the past three months. Inflation remains elevated with both the Bank of Canada’s core rate and the all-items inflation rate holding above the 2% target. With the economy running in a state of excess demand, housing price inflation strong and wage growth accelerating, inflation pressures are expected to remain elevated.

Against this fundamental backdrop, the Bank of Canada would normally be raising interest rates to ensure that inflation rates fall back to the 2% target. However the significant dislocation in the short-end of Canada’s financial market and weakening in equities during the period of global financial market volatility will likely keep the Bank concentrating on maintaining liquid markets so that financial market volatility does not spill over into the real side economy.

Worries about the spillover from the financial markets into the economy will likely keep interest rates lower than in our previous forecast. We have shifted the timing of the next Bank of Canada rate hike in our forecast to the first quarter of 2008, a change from our previous view that the Bank would raise the policy rate by 25 basis points on September 5. Interest rates will remain lower as investor risk aversion will result in continued buying of safer government securities. The two-year rate is forecast to end 2007 at 4.5% and the 10-year rate 4.70% (from 5.10% for both the two-year and 10-year yields in our August 1 forecast).

In early 2008, the economy’s strong momentum and the waning of risk aversion will see the Bank of Canada move to tighten policy, with the overnight rate forecast to rise to 5.25% over the first half of 2008 (up 75 basis points). Two-year yields are forecast to rise to 5.3% with 10-year rates peaking at around 5.45%, little changed from our previous forecast.

This article is courtesy of RBC Economics and research

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