2 February 2011

Economics
Beyond the Cycle
www.sgresearch.com

American Themes
The end of dis-inflation
US Economic Team
Aneta Markowska (1) 212 278 6653
aneta.markowska@sgcib.com

Our baseline scenario sees a low US inflation environment for the next two years, but risks are skewed to the upside. We think that the deflation story has run its course and as core inflation bottoms out in the next few months, investor focus will shift to upside risks. By March, the Fed may have to acknowledge that core inflation is no longer trending down.
Core inflation low, but bottoming Base effects suggest that by March, core CPI may rise to

Rudy Narvas (1) 212 278 76 62

rudy.narvas@sgcib.com

Brian Jones (1) 212 278 69 55

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Martin Rose (1) 212 278 7043

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1.1% (vs. a low of 0.6% seen late last year). There are further upside risks, as service inflation and public transportation costs could surprise at the start of 2011.
Risks biased to the upside Recent wage trends suggest that structural unemployment may

be higher than most estimates. Asias impact on US inflation is also shifting into rev erse. Commodity prices are not being passed through, but add to headline inflation. Food prices are also pressured higher. These factors are not imminent risks, but they do point higher inflation in the medium term.
Feds biased reaction function is yet another risk At the next FOMC meeting, the Fed may

have to change its language on core inflation from trending lower to stabilizing at low levels. That said, the Feds biased reaction function remains skewed t oward fighting unemployment, which suggests a slow exit. Consequently, we do not look for hikes until the second half of 2012. Longer term, the Feds bias is yet another factor adding to upside inflation risks.
Chart 1: Core CPI shifting past the low point Balance of risks on the upside
4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 -0.5 y/y %

Higher NAIRU CPI Core Commodity pass-through

Imported inflation Inflation expectations

Policy error

SG Forecast

High unemployment Inflation expectations

-1.0
95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

Source: Global Insight, SG Cross Asset Research/Economics

Macro

Commodities

Forex

Rates

Equity

Credit

Derivatives

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A benign inflation scenario with upside risks

Our baseline view is that the US will maintain a low inflation environment for the next two years and likely even longer. This is consistent with a top-down approach which incorporates a large output gap and stable inflation expectations. This approach at the beginning of the crisis suggested that core CPI should bottom at around 1% and remain near that level for a while. Having undershot the target modestly in Q4, the model now suggests that core inflation should be stabilizing at current levels and move gradually higher over the next few quarters. While the projected rise in core inflation will be very gradual, we believe that the risks around this benign scenario are shifting to the upside. These risks are both short-term and long-term in nature. Among the short-term risks are rising service sector inflation and potential spikes in public transportation costs. Longer-term risks include uncertainty about structural unemployment, potential pass-through of commodity costs and imported inflation from the emerging world.

Top-down model sees low inflation for some time

Our top-down model is based on employment gap and inflation expectations. The latter is a crucial factor in preventing a drift to deflation. As shown below, without well-anchored expectations, core CPI would likely already be in negative territory. This is where the Fed has the greatest influence over the inflation outcomes. We believe that the Feds efforts have been instrumental in putting a floor under inflation expectations.
Chart 2: Phillips curve suggests inflation is bottoming
% 13 11 9 7 5 3 1 -1 -3 60 65 70 75 80 85 90 95 00 05 10 15
Source: Global Insight, SG Cross Asset Research/Economics

Core CPI based on employment gap w ith w ell-anchored expectations

Assuming that unemployment declines gradually (ending 2011 at 8.7% and 2012 at 8.4%) and inflation expectations remain well anchored, core inflation should rise gradually from the current 0.7% yoy. We look for a 1.3% core CPI rate by the end of the year. The model suggests that the Feds inflation target is unlikely to be achieved until 2 014. In the context of the top-down model, there are two main sources of risk to the inflation outlook.

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1. 2.

Inflation expectations, which can have a great influence on actual outcomes The estimated size of structural unemployment (or the so-called NAIRU)

In addition, there are several risks exogenous to our simple model. Those include:
While we look for a low inflation environment, we believe that the balance of risks lies on the upside.

3. 4.

Higher commodity prices Higher import prices as China starts to export deflation

Although we look for a low inflation environment, we believe that the balance of risks lies on the upside. In addition, looking at inflation from a bottom-up perspective also suggests that risks are tilted to the upside. In the following sections, we will address these risk factors individually.

What could go wrong? Risks largely on the upside

Inflation expectations Stable, but subject to policy errors
Inflation expectations are a key driver of actual inflation outcomes. In our top-down model, we include long-term consumer expectations (5-10yr) and assume that they remain well
Inflation expectations are a twosided risk, but the window for realizing downside risks may be closing. Meanwhile, the (upside) risk of a policy error is rising.

anchored. This is consistent with evidence to date. Long-term consumer expectations have been stuck in a very low range and have not been influenced by the low core inflation readings. One reason may be the fact that wage growth has been surprisingly resilient. Average hourly wages have stabilized around 2.0% after decelerating from roughly 4% growth during the expansion years. That said, causality probably goes both ways and stable inflation expectations may be the reason behind wage resiliency (more on wages later).

Chart 3a: Consumer expectations

14.00

Chart 3b: Forecaster expectations

14.00
Core CPI Exp. next year

12.00
10.00 8.00 6.00 4.00 2.00 0.00

12.00 10.00 8.00 6.00 4.00 2.00 0.00

Core CPI Splice - Livingstore and SPF (post 1991)

Exp. 5-10 years

79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11
Source: Global Insight, SG Cross Asset Research/Economics

79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11

We view inflation expectations as a two-sided risk. That said, the window for realizing downside risks appears to be closing as unemployment starts to move lower. The Fed has been instrumental in putting a floor under inflation expectations, but its deflation-fighting resolve also represents an upside risk for the future. Higher food and energy prices as well as rising import prices could amplify that risk.

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NAIRU How big is structural unemployment?

Recent wage resiliency suggests NAIRU could be higher than most economists assume. This is not an immediate risk, but could lead to a policy error in the next 2-3 years.

There is a considerable debate about just how much of current unemployment is structural vs. cyclical. This is not only an academic debate, but one that has strong policy implications. Fed officials seems to be divided on the issue, though the Feds official long-run unemployment projection is just 5.0%-5.3%. Official CBO figures, often used as a benchmark, put NAIRU at 5%. Market estimates seem to be somewhat higher. Our own gauge, derived from a pure statistical filter, puts it around 6.3%.
Chart 4b: Wage growth suggests NAIRU may be 7.5%
Unem ployment Rate

Chart 4a: Where is NAIRU?

12.0 11.0 10.0 9.0 8.0 7.0 6.0 5.0 %

6.0 % 5.0

Average Hourly Wages, 3m ann

Em ploym ent Gap (based on SG NAIRU)

-4.0 -3.0

NAIRU #1: CBO estim ate NAIRU #2: SG Estim ate

-2.0
4.0 -1.0 0.0 1.0 2.0 2.0

3.0

4.0
3.0 2.0 49 54 59 64 69 74 79 84 89 94 99 04 09

1.0

One way to restore the relationship is b y assuming NAIRU at 7.5%

85 87 89 91 93 95 97 99 01 03 05 07 09 11

3.0
4.0

0.0

Source: Global Insight, SG Cross Asset Research/Economics

US wage growth by sector:

AHE, y/y Current 10yr avg Construction 2.6 2.9 Financial 2.6 3.7 Education/Health 2.6 3.7 Information 2.4 3.1 All Private 2.0 3.1 Goods Producing 2.0 2.9 Services 2.0 3.3 Utilities 1.9 2.9 Wholesale Trade 1.9 2.8 Mining/Logging 1.8 3.7 Prof & Bus services 1.8 3.9 Wholesale & retail trade 1.8 2.4 Retail Trade 1.7 2.0 Trade/Transport/Utilities 1.6 2.4 Durable Mfg 1.6 2.8 Manufacturing 1.5 2.6 Transport/Warehousing 1.3 2.5 Nondurable Mfg 0.7 2.3

There is some risk that the NAIRU might be even higher than we think. Recent wage trends which are bottoming around 2% - suggest that labor market slack is no bigger than it was during the previous two recessions. Taking the unemployment rate at face value, the relationship suggests that the NAIRU might be closer to 7.5% (see Chart 4b). Importantly, the recent wage resiliency is broad-based and not limited to a few sectors. The possibility of a much higher NAIRU is not a near-term inflation risk because even at 7.5%, there is plenty of slack in the labor market. However, as unemployment drops toward 8%, the risk of a policy error will begin to rise quickly.

Service costs Sticky, and already moving higher

A bottom-up analysis also suggests some potential for upside surprises, possibly even in the near-term. Much of the recent disinflation was driven by the housing component. However, rents in the CPI have bottomed out, and given their sticky nature, this should not go unnoticed (see chart below). The impact of rent re-inflation on core CPI has been masked by recent softness in goods pricing. However, we attribute the latter to volatility rather than a weakening trend. Indeed, the

Service inflation has likely bottomed. This has been a key driver of disinflation in the past two years.

recent pickup in demand and ongoing depletion of inventories suggest that the weakness is unlikely to last. Longer term, goods pricing may also be pressured higher as Asias deflationary influence is reversing. With service inflation reaccelerating (albeit slowly) and goods inflation firming up, core CPI will be pressured higher.

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Chart 5a: Rents in the CPI in decisive bottom

8.0
%

Chart 5b: Recent deflationary episode driven by services

7.0 % 5.0 CPI Services

Rent of primary residence, 6% of CPI Owners' equivalent rent, 25% of CPI

7.0 6.0 5.0

CPI Durables

6m growth rate annualized

3.0

4.0 3.0 2.0 1.0 0.0 -1.0 -2.0 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

Source: Global Insight, SG Cross Asset Research/Economics

1.0

-1.0

-3.0

Asia exporting deflation

90 92 94 96 98 00 02 04 06

Asia exporting inflation?

08 10

-5.0

Import prices Is China starting to export inflation?

Asias impact on US inflation is shifting into reverse. After nearly 15 years of exporting disinflation, Asia - led by China - is starting to export inflation. This influence has already been evident for several years in energy and raw commodity prices, but in the not-too-distant future it could start showing up in prices of manufactured goods. Indeed, Asias impact on US inflation reached an inflection point back in 2003, when durable goods inflation bottomed out. It is remarkable that despite a much deeper manufacturing recession in the US, durable goods pricing in this episode has been much more resilient than in 2001-2003. The only way we can explain this is by focusing on the global output gap rather than the US alone.
Chart 6a: From China to US import prices
China CPI (LHS) 10 8 6 4 2 0 -2 -4 00 02 04 06 08 10
Source: Global Insight, SG Cross Asset Research/Economics

Chart 6b: From China to US consumer prices

China CPI (LHS)
6.0

US imports from China, lagged by 4 months (RHS)

10

US Core CPI ex services, lagged by 20 months (RHS)

5 4 3 2

5.0
4.0 3.0 2.0

8
6

4
1 2 0 0 -2 -1 -2 -3 00 02 04 06 08 10

1.0
0.0 -1.0 -2.0

-3.0
-4.0

-4

As our Asian economists have long pointed out, Chinese inflation dynamic is shifting from a cost-push to a demand-pull inflation, which should be more persistent in nature. This shift is consistent with Chinas efforts to rebalance its growth toward domestic consumption. Chinas rebalancing, combined with rising food costs is also putting upward pressure on wages, and ultimately on the prices of Chinese goods.

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For the US, Chinas rebalancing ultimately point s to higher inflation. The question is not if, but when. Historically, we have found a roughly four-month lag between Chinese CPI and US import prices from China. This relationship suggests import prices should be heading higher over the next four months. However, it may be a while before we see the impact in retail prices where the lag can be as long as one and a half years. Historical lags notwithstanding, anecdotal evidence suggests that import price pressures are already bubbling up under the surface. We have seen numerous reports in recent weeks about US importers facing significant cost hikes and scrambling to find lower cost production centers1 2. Alternative markets Vietnam, Thailand, or India to name a few may help mitigate some of the pressures, but moving production may take months or even years. Moreover, these markets may not be large enough to match Chinas manufacturing might.

After exporting deflation for the past 10 years, Asias impact on global price trends is shifting into reverse.

Commodity prices How much can be passed through?

Commodity prices are inflationary only if they can be passed through to final goods prices. That has not been the US experience in recent years. Instead, the 2007-2008 run-up in energy prices proved to be a recessionary impulse rather than an inflationary one. Businesses were unable to raise prices in the context of global competition and weak domestic consumption. In an effort to offset the pressure on margins, they chose to reduce labor. This only added to the consumer weakness, exacerbating the recession already in progress.
Chart 7: Limited pass-through; rising commodity prices a risk to profit margins
60
%

Rising commodity prices are a bigger risk for profit margins than for core inflation as businesses have no ability to pass them through to consumers. It would take energy price increases in excess of 20% before pass-through becomes a risk.

40 20 0 -20 -40 -60 -80 73

High pass-through; margins preserved

Low pass through; margins squeezed

77

81

85

89

93

97

01

05

09

The index represents the ratio of core PPI for final goods vs. the total PPI at the crude production stage. Positive readings indicate higher core PPI, which suggest that businesses are very successful passing through rising food and energy costs. Negative readings suggest limited pass-through and pressure on profit margins.
Source: Global Insight, SG Cross Asset Research/Economics

While things may change in the future, for now we continue to see similar difficulties in passing through rising material costs. Our pass-through indicator in Chart 7 shows that producers are absorbing rising costs in their profit margins. The difference between now and 2008 is a better macro backdrop and strong productivity helping to offset the cost hikes. However, if commodity prices were to rise sharply, the recovery could be threatened. Of course, businesses can only absorb rising material costs to an extent. At some point, either margins will collapse completely, triggering a recession, or else they will have to start passing
1 2

See Rising Chinese Inflation to Show Up in US Imports, NYT, January 11, 2011 See Inflation in China May Limit US Trade Deficit, NYT, January 30, 2011

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some of the cost hikes. Yet, the threshold for pass-through is relatively high. Incorporating an oil variable into our top-down model suggests that in order to change the core inflation trajectory and push core CPI above 2%, oil inflation would need to rise in excess of 20% for several years.

Conclusions Fed and market impact

Inflation outlook: We do not think that inflation in the US will become a serious issue over the next two years. But the deflation story has run its course, and as core CPI bottoms out in the next few months, investors focus will shift to upside risks. Such a shift in perception is
We see a low inflation environment with upside risks. Fed is likely to be slow exiting, which raises a risk of a policy error in the medium-term. Treasuries are more sensitive to long-term inflation expectations than short-term inflation outcomes. Not an immediate risk, but could materialize in the next 2 years.

warranted: US service inflation is bottoming and with the global output gap already closing, goods prices may soon follow. Fed outlook: What does this all mean for the Fed? In its latest FOMC statement, the Fed noted that despite rising commodity prices, core inflation measures are trending lower. The next FOMC meeting is March 15 and if our CPI forecasts are correct, that characterization will no longer be valid. The Fed may have to replace it with a statement that core inflation is stabilizing at low levels. This is far from signaling imminent tightening, but it is a subtle signal that policy accommodation is coming to an end. The Fed still sees inflation risks as relatively low and high unemployment rates will continue to bias the Feds reaction function towards excessive accommodation. The Fed has signaled consistently that it will prevent deflation at any cost and that suggests that it will exit very slowly. Consequently, we do not look for rate hikes until the second half of 2012. Longer-term, the Feds asymmetric reaction function is another factor pointing to upside inflation risks.

SG Fundamental Treasury model results:

OLS Model Results
Coefficients: Intercept Real Fed Funds Inflation Expectations Inflation Volatility R-squared

Bond yields: In our fundamental model for Treasury yields, inflation impacts yields in two ways: (1) via actual inflation outcomes, which influence the real short-term rate, and (2) via long-term inflation expectations, which are an important dependent variable. We also allow for two liquidity regimes which are determined by Fed policy.

2.51 0.42 0.57 1.65 0.80

Chart 8: Fundamentals should drive Treasury yields higher over time

16.0 % 14.0 Actual OLS Fit (standard regression) STR Fit (w ith tw o liquidity regimes)

12.0

STR Model Results

Coefficients: Regim e 0: Norm al liquidity Intercept 1.52 Real Fed Funds 0.20 Inflation Expectations 1.18 Inflation Volatility 1.24 Regim e 1: Excess liquidity Intercept 1.99 Real Fed Funds Inflation Expectations Inflation Volatility R-squared 0.34 0.56 1.91 0.83

10.0

8.0
6.0 4.0

2.0
0.0 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14

OLS model is a standard regression on real fed funds rate, inflation expectations and inflation volatility. STR model is a smooth transition regression which allows for smooth switching between two liquidity regimes. The regimes are determined by Fed policy.
Source: SG Cross Asset Research/Economics

The results suggest much greater sensitivity to long-term inflation expectations, although clearly there is some vulnerability to short-term inflation surprises. Moreover, the sensitivity
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increases sharply under normalized liquidity conditions, which suggests some complacency during periods of loose liquidity. Under a loose liquidity regime, every 100 bp shift in long-term inflation expectations triggers a 56 bp adjustment in the 10-year yield in our model. However, under normalized liquidity the impact is 118bp. The results suggest that a policy error discussed above could prove to be a double whammy for the Treasury market: first by forcing investors to mark up their inflation expectations and then by forcing the Fed to respond. While short-term inflation surprises could push Treasury yields higher, the bigger risk for the market would be an upward shift in inflation expectations. We dont see the latter as an immediate risk, but one that could materialize over the next two years.

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GLOBAL ECONOMICS
Head of Global Economics Michala Marcussen (44) 20 7676 7813
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Euro area Klaus Baader (44) 20 7676 7609

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James Nixon (44) 20 7676 7385

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Vladimir Pillonca (44) 20 7676 7863

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Michel Martinez (33) 1 42 13 34 21

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United Kingdom Brian Hilliard (44) 20 7676 7165

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Americas Stephen Gallagher (1) 212 278 44 96

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Aneta Markowska (1) 212 278 66 53

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Alejandro Cuadrado (1) 212 278 73 13

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Rudy Narvas (1) 212 278 76 62

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Brian Jones (1) 212 278 69 55 brian.jones@sgcib.com Asia Pacific Glenn Maguire (852) 2166 5438

glenn.maguire@sgcib.com

Takuji Okubo (81) 355 49 5560

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Wei Yao (852) 2166 5437

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Joseph Lau (852) 2166 5441

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Thematic Research Vronique Riches-Flors (33) 1 42 13 84 04

veronique.riches-flores@sgcib.com

Research Associates Lydia Boussour David Tam

Martin Rose Samuel Slama

Mehreen Khan

Ramzi Berrima

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