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Date
November 3, 1997
Editors:
New York: Patrick Paradiso
Tel.: (212) 469-7352
Frankfurt: Peter Cornelius
Tel.: (69) 910-31737
London: James Barty
Tel.: (171) 545-2089
Technical Assistant:
New York: Marie Walsh
Tel.: (212) 469-7326
Inside this Edition
Editorial note: World growth following Asian
crisis ............................................................... 2
This editorial note briefly discusses the implications
of the recent turmoil on the Asian markets for
world economic growth in the near term. It
appears that the trade implications for Europe and
the US are muted, and indeed, the Asian market
turmoil does not negate the inflationary threat for
either continent.
Whither the US Economy? ........................... 5
The key question facing investors and the Federal
Reserve is, to what extent has the outlook for the
US economy changed in light of the turmoil in the
global currency, equity and debt markets?
Arguments on the development of
inflation ......................................................... 7
Inflation is not – as sometimes maintained – dead.
Not even in this ”new” world of increasing global-
isation. An analysis of the fundamental determi-
nants of inflation shows that the internal and exter-
nal influences in the USA on the one hand, and
continental Europe/Japan on the other, are diamet-
rically opposed.
Japan BoJ’s autumn quarterly economic
outlook ......................................................... 16
The BoJ said that the recovery has not yet been
derailed. But, even ahead of the recent equity
market turmoil, regional managers have become
more cautious than at any time since the end of
the Endaka back in CY95.
Banking on higher rates ............................. 19
The Bank of England’s Monetary Policy Committee
meets again this week. The general tone of the
data has been robust and with most indicators
suggesting continued above trend growth, there
is good reason to think that the inflation target will
not be met in the medium term. While we think a
rate rise is warranted, the equity market turmoil
may cause the Bank to delay a rate rise for a
month.
Deutsche Morgan Grenfell Market Issues November 3, 1997

Editorial note: World growth following

Asian crisis
Last week’s market turbulence coupled with the continuing problems of Asia have
raised the question of whether global growth is about to turn. We believe that the
Asian markets have been economic difficulties faced by Asia are indeed very serious and could further
hit by serious problems worsen, with the two largest economies, Japan and China, potentially suffering
recently... particular hardships. Clearly, the region’s much weaker growth outlook reduces the
countries’ absorption capacity so that exports to Asia could fall significantly. At the
same time, the sharp devaluation of the countries’ currencies has considerably
increased the competitiveness of their exports. This has raised concern that the
...here we examine the growth prospects outside the region may also need to be revised downwards, a
global implications concern which has already had a powerful impact on financial markets, with stock
prices having fallen sharply in virtually all developed and emerging markets and
capital fleeing into quality, i.e. bonds and liquidity.

Although huge in population terms, Asia (excluding Japan), accounts for just 8½%
of world GDP. While its share in world trade is considerably higher, its export and
Europe’s exposure to imports are heavily concentrated on the region. As we have discussed in the
Asia (ex Japan) is September issue of our Economic and Financial Outlook, Europe’s exposure appears
limited... rather small, with only just over 7% of European exports going to Asia (excluding
Japan). The four most affected countries, that is, Thailand, the Philippines, Indonesia,
and Malaysia, account for just 1.7% of European exports. Even under extreme
...and even the US assumptions, economic growth in individual European countries with the highest
exposure is not enough exposure would be limited to about 1/3 percentage point. It is therefore unlikely
to cause concern that the substantially weaker growth outlook in Asia will seriously jeopardize the
current cyclical upswing in Europe. Asia’s share with respect to US exports is
higher but still accounts for less than one-fifth of total exports (ex Japan). It is
therefore unlikely that the impact of the Asian crisis will be sufficient to reverse the

Asia is slowing but world growth remains robust Contributions to World Growth
14 forecast 14 8 forecast 8
OECD
Real GDP, % yoy Real GDP, % yoy

AAAA
World
12 12
AAAA
Latin America World

AAAA
AA Asia 6
AAAA Asia 6
10
AA AA AA
10
AAAA OECD

AA AA AA AA AAAA Latin America

8
AA AA AA AA AA 8
4 4
AA AA AA AA AA AA AA AA
6
AA AA AA A
AA AA AA AA AA 6
AA AA AA A
AA AA AA AAA
AA AAA
AA AA AA
4
AA AA AA A
AA AA AAA
AA AAA AAA 4 2
AA AA AA
2
AA AA AA A
AA AA AAA AAA AAA AA AA AA
2
AA AA AA A
AA AA AAA AAA AAA 2
AAAAA AAAAA AAAAA
AA AA AA A
AA
A AAAAA AAA AAA AAA
0
AA
91 AA
92 AA AA
93 94 A 95 96 A 97 A 98 A 0 0
1996 1997 1998
0

Asia's slowdown blunts world growth acceleration Liquidity flows and the federal funds rate
1 1 20 whenever liquidity rises 20
forecast
R eal GDP, % yoy Federal funds rate, % above Fed Funds,

AAAA
interest rates head
World 15 15
AAAA
higher
O ECD

AAAA
0.5 A sia 0.5 10 ➍ 10
Latin Am erica
➋ ➌
AA AA AA 5 ➊ 5
AA
AA AA AA
AA AAA AAA
➎
0 AA AAA AAA 0 0 0

-5 Money and financial flows -5

12mma, % yoy
-0.5 -0.5
1996 1997 1998 -10 -10
1960 1966 1972 1978 1984 1990 1996

2 Economics Driving Market Forces

November 3, 1997 Market Issues Deutsche Morgan Grenfell

strong forward momentum of the US economy. Including Japan, where spill-over

Nor should asset price effects from the rest of Asia could seriously worsen the growth outlook and the
volatility be too great a country’s absorption capacity, the trade effects on Europe and the USA would
concern... certainly be greater but still not large enough to throw the economies off track.

Other risks could arise from the high volatility of asset prices. However, while the
sharp fluctuations in the financial markets represent a threat to broader financial
stability in some countries, they are unlikely to threaten US prosperity or the
economic recovery in Continental Europe. Even the 1987 crash, whose magnitude
...as long as the stock was significantly larger, does not appear to have had any substantial effects on
declines do not consumption and investment. Provided that last week’s decline in stock prices
accumulate does not cumulate, our current growth scenario thus remains largely intact. We
will, of course, closely monitor the developments in the financial markets and adjust
our forecasts if necessary.

Mr. Greenspan welcomed the correction of stock prices and said “….it is quite
conceivable that we will look back at this episode…as a salutary event in terms of
its implications for the macroeconomy”. This statement has led most observers to
While the Fed are now believe that the Fed will remain on hold at least for the time being. As long as asset
unlikely to hike rates... prices remain highly volatile and the overall situation remains unsettled, we agree
that the Fed is unlikely to tighten monetary policy. However, we share Mr. Greenspan's
judgement that inflation not deflation is the most likely scenario in the longer term,
...we remain cautious on and with virtually no slack left in the economy the stock market correction is
inflation expected to provide only temporary relief on the interest rate front.

Even in continental Europe where unemployment is high, much of this is not

available for increased output for structural reasons. Measures of spare capacity
The recovery in Europe based on GDP, the so-called “output gap” show a small margin of slack, and in the
would appear to be still case of Europe’s biggest economy, Germany, the output gap is closing rapidly. In
in place

Growth is strong in the US... ...and the UK...

4 4 4 4
1997
Real GDP, % yoy 1997 1998 Real GDP, % yoy 1997 1997

1998
3 3 3 3

1998
1998
2 2 2 2

DMG
DMG
forecast
Consensus forecasts forecast
Consensus forecasts
1 1 1 1
J F M A M J J A S O Full Year J F M A M J J A S O Full Year

...and is picking up in Germany... ...but is depressingly low in Japang p

4 4 4 4
DMG DMG
Real GDP, % yoy Real GDP, % yoy
forecast forecast

3 1998 3 3 3
1998

1997
1998
1997
2 2 2 2
1998
1997
Consensus forecasts Consensus forecasts
1997
1 1 1 1
J F M A M J J A S O Full Year J F M A M J J A S O Full Year

Driving Market Forces Economics 3

Deutsche Morgan Grenfell
Asian financial excess is
to blame...
...an inventory correction
will not help...
...a pessimistic stance is
warranted
In particular, we think
China is at significant risk
4 Economics
Market Issues November 3, 1997
our view, the turmoil in the financial markets and the potential real spill-over effects
from Asia will not fundamentally change this situation. The recovery will gain
momentum and European interest rates are likely to head up, too.
Asia’s economic woes can be traced to the after effects of financial excess. The
Japanese corporate sector has over-invested, its banks have over-lent and its
consumers have over-saved. This week’s industrial production figures confirm that
a staggering 5.3% average yoy increase has occurred since the consumption tax
hike was implemented in March. Given that demand has fallen sharply, the inevitable
inventory correction is likely to be severe and sharp. Japan is also the most heavily
exposed industrial country with respect to Asia. Strong banks would be able to
withstand loan losses associated with the ASEAN-4 crisis. Japanese banks do not
fall into this category. Forecasters and analysts are deeply pessimistic. But we
believe that the projections for both profits and growth are not pessimistic enough.
The stock market is vulnerable, and interest rates already at historically low levels
could even fall further.
In the rest of Asia, we believe that the crisis has further to run and may broaden.
There is increasing risk that economic growth in China could decline significantly.
Inflation has declined almost to zero and it is very unusual for this to occur without
the economy going into recession. The performance of “red chip” stocks fell
severely even before the Hang Seng index took its tumble. Finally, the structural
adjustments for China’s state-owned enterprises, whilst essential to the long-term
health of the economy, have short-term negative consequences.
The outlook of emerging markets in the context of the Asian crisis will be examined
in a report to be published next week. This week’s Market Issues includes four
articles on industrial countries. The first, it addresses the question whether the
crisis has fundamentally changed the growth outlook for the USA and discusses
the potential impact on Fed policies. The second paper provides a general discussion
of inflation trends and examines whether the co-existence of strong economic
growth suggest a new paradigm. Third, the latest Bank of Japan report is discussed
in light of the ongoing economic contraction. Finally, we examine recent economic
trends in the United Kingdom and the implications for monetary policy.
Steven Bell, London, (171) 545 2288
Peter Cornelius, Frankfurt, (69) 910 31737
Driving Market Forces
November 3, 1997 Market Issues Deutsche Morgan Grenfell

Whither the US Economy?

Assessing the impact from the turmoil in
the global financial markets
The key question facing investors and the Federal Reserve is, to what extent has
the outlook for the US economy changed in light of the turmoil in the global
Has the growth trend in currency, equity and debt markets? And, if the turmoil in the global financial
the US changed? markets cools the pace of economic activity, will the slowdown be sufficient to
affect the budding pressures in the US labor markets?

Plainly, the sudden drop in US equity prices is an indication that investors have
Investors think so, as lowered their estimates of growth and profits. But, given the unsettled conditions
they have lowered their in the domestic and global financial markets, it is difficult to quantify with any
estimates on company certainty the size and the length of the slowdown in the US economy. For that
profits reason and that reason alone, the Fed no doubt is on hold until it can get a better
sense of the basic trend in the US economy.

From our perspective, before one attempts to look ahead it is important to ascertain
Where do we stand? the general trend of the economy today. Only then can one assess the change in
growth from a variety of factors.

Based on the available data it seems clear that the US economy has been on a fast
growth path. Not only did Q3 real GDP rise 3.75% annualized, but the 4.0% rise in
Today, the basic growth real GDP over the past year represented the fastest twelve-month growth
trend is fast performance of the current business cycle. Moreover, the US economy would
appear to have fairly strong forward momentum, given the 5% gain in Q3 final sales
and a pace of inventory building that was nearly halved in the latest period.

Against a backdrop of fast growth with solid forward momentum, analyzing changes
in the growth outlook for the US economy rests on weighing the effects of a
How much will it be number of complex forces, chief among them the reduced growth prospects in
affected? Asean economies; the recent losses of financial wealth and impact on consumer
demand; and the recent declines in US interest rates and the trade-weighted value
of the US dollar.

Of the Asean countries (Thailand, Philippines, Indonesia and Malaysia) initially hit
with currency turmoil, US export exposure is relatively minor and narrowly-based.
In 1996, for example, US export exposure totaled only USD 25 bn, or roughly 4% of
US exports will take a the total. In addition, almost two-thirds of export volume was concentrated in two
small hit categories: electrical machines and nuclear reactors. More recently, currency
turmoil has spread to other Asean countries, most notably Hong Kong, where US
export exposure is somewhat larger.

Nonetheless, the impact on the US economy would seem to be measurable but

small and the impact on US labor markets would be even less. That is because
while there is little doubt growth in Asia will slow, it still is expected to be positive.
The impact on US labor As a result, US exports should not collapse as they did after the Mexican peso was
markets will be even devalued in 1995 and that country plunged into a deep recession. Also, the two
smaller industries most affected by the economic changes in Asia will be hi-tech and
engineering and construction. Given the change in currency, trade flows in hi-tech
equipment will swing sharply in favor of Asean firms. But, since hi-tech firms are
largely capital-intensive, the impact on US labor markets will be small. US engineering
and construction firms also will take a hit because Asean countries will have to
slow, delay or cancel a number of large infrastructure projects. But here too the
impact on US labor markets will be small, since these firms rely heavily on labor in
the local markets.

Driving Market Forces Economics 5

Deutsche Morgan Grenfell
Recent financial losses
are very small when
viewed against longer
trend
IMF aid package should
help begin to stabilize the
Asean crisis, while faster
growth in Europe could
lift export growth
Lower rates should be a
powerful stimulant to
growth
Big difference between
1987 and 1997: Liquidity
flows are rising today
versus contracting back
then
6 Economics
Market Issues November 3, 1997
Similarly, the recent loss of financial wealth, given the 5% pullback in equity prices
since October 1, should have little net effect on consumer demand. Admittedly,
the recent sell-off has been swift and sharp but it must be viewed against the
longer trend. Equity prices are still up 22% for the year, and over 100% in the past
three years. Thus, even though a much higher percentage of individuals have
leveraged their stock portfolios today as compared to 1987, it would seem that the
store of financial wealth that has been created by the runup in equity prices is still
a net plus for consumer spending.
Admittedly, the effects of lost trade and reduced consumer demand emanating
from the currency crisis and the sell-off in the equity markets are subject to change
because both situations have yet to stabilize, and there is evidence that the currency
turmoil is spreading to other emerging markets. However, the announcement that
the IMF and other sources will provide a emergency aid package of about USD 23
bn for Indonesia should help begin to stabilize the situation in Asia. In addition, while
growth in emerging markets could well prove to be less in 1998 than first thought,
growth in Europe — a key export market for the US — looks to be on the rise. Also,
the single most important lesson learned from the 1987 stock market crash is that
consumer demand over the intermediate- to long-run suffers very little from a crash
in financial asset prices as long as other more fundamental factors such as jobs,
wage growth, cash flow and interest rates are positive.
Importantly, the recent fall in interest rates, and to a lesser extent the modest fall in
the trade-weighted value of the dollar, should be a powerful stimulus to offset
reduced trade flows and lower equity prices. Indeed, the fall in interest rates will
allow individuals to extend the reliquification process, freeing up billions of dollars of
cash flow that will be spent in 1998. Further, the fall in the dollar will be a slight
positive for profits and margins.
In the end, the powerful uptrend in liquidity flows in the US should not be interrupted,
but may in fact be lifted by the recent fall in interest rates. In fact, one of the key
differences between the stock market crash of 1987, the Mexican crisis of 1995
and 1997 is the different trend in liquidity flows. In 1987 our liquidity index made a
noticeable downturn while in 1995 the index was posting only smallish gains.
Today, liquidity flows are accelerating to new cyclical highs. With a more positive
liquidity backdrop, the basic trend in growth in the US should be little changed over
the intermediate- to long-run, but the composition most likely will be different than
initially expected. Internally-generated demand could prove to be somewhat stronger
and external demand somewhat weaker.
Joseph Carson, New York, (212) 469-7540, Joseph LaVorgna (212) 469-7329
Y/Y
Percent Money & Financial Flows
10.0
8.0
1987 1997
6.0
4.0 1995
2.0
0.0
-2.0
J F M A M J J A S O N D
Driving Market Forces
November 3, 1997 Market Issues Deutsche Morgan Grenfell

Arguments on the development of

inflation
Diverging fears in the big three
In the USA, the danger that inflation will accelerate and lead the Fed to hike rates is
currently a central theme in the economic debate. In Japan and much of Europe, on
the other hand, all is relatively quiet on this front. The rate of consumer price
increase in many European countries – even in some former high-inflation sufferers,
such as Italy – is a mere 1 ½-2%. Moreover, very few observers expect price
pressure to build up perceptibly in the foreseeable future, in view of the weakness
of economic growth, held down by fiscal drag. But does this mean Europe has
been cured of price risks? Is inflation – as often claimed – really dead? And is the
USA about to see a rise in inflation which will force the Fed to act? Will the central
banks manage the balancing act between, on the one hand, tightening monetary
conditions early enough to prevent their economies from overheating and, on the
other, proceding carefully enough to avoid curbing economic growth too strongly,
and thus achieve steady growth?

Diametrically opposed effects

Inflation in USA is fuelled
by internal influences and
dampened by external
factors, while the
situation is reversed in
continental Europe/Japan
An analysis of the fundamental determinants of the level of inflation shows that
with the exception of the UK and possibly Ireland and Finland, the internal and
external influences in the USA on the one hand and Europe/Japan on the other, are
diametrically opposed. Whereas in the USA internal influences are fuelling inflation
and external factors are dampening it, the situation in continental Europe/Japan is
quite the reverse.

Inflation outlook: favourable in Europe and Japan ...

In continental Europe
inflation should remain
moderate, averaging 2%
next year ...
In many European countries and Japan, the fundamentals suggest prices will
continue to develop moderately. Only in the UK, where the business cycle is
already far advanced and growth has for some time been above the long-term
trend, is inflation (core rate, i.e. excluding mortgage interest payments) likely to
accelerate, to 3 ½% (4% including mortgage interest payments), as early as the
second quarter of 1998. In continental Europe the weaker currencies mean that
inflation risks are being counteracted by strongly dampening internal influences
(e.g. weak growth, output gaps, modest wage growth). We therefore expect
inflation to remain moderate, averaging 1.8% this year (2% including the UK) and
increasing slightly to 2% (2 ¼%) in 1998 as the cyclical recovery progresses and
draws greater support from domestic demand. This would still be well below the

Quarterly Forecasts
Consumer prices, % yoy

1995 1996 1997 1998

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
USA 2.9 3.1 2.6 2.6 2.8 2.8 3.0 3.2 2.9 2.4 2.3 2.4 2.7 3.2 3.5 3.6
Japan 0.2 0.0 0.1 -0.6 -0.4 0.1 0.2 0.4 0.6 2.0 2.1 2.5 2.5 1.2 1.2 0.8
Germany 2.0 1.9 1.7 1.7 1.6 1.5 1.4 1.4 1.7 1.6 1.9 1.9 1.9 2.0 1.6 1.7
France 1.7 1.6 1.8 1.9 2.1 2.4 1.9 1.7 1.5 0.9 1.3 1.4 1.4 1.6 1.6 1.5
Italy 4.4 5.5 5.7 5.9 5.0 4.2 3.5 2.7 2.4 1.6 1.5 2.1 2.3 2.3 2.4 1.7
United Kingdom 3.4 3.4 3.7 3.2 2.8 2.3 2.2 2.6 2.7 2.7 3.5 3.6 3.7 4.1 3.5 3.5
EU 3.1 3.2 3.1 3.1 2.8 2.6 2.3 2.3 2.1 1.7 2.1 2.3 2.3 2.5 2.3 2.2
Continental Europe 3.0 2.9 2.8 2.8 2.6 2.4 2.1 1.9 1.8 1.4 1.6 1.8 1.9 2.0 2.0 1.8
Industrial countries 2.5 2.7 2.4 2.3 2.3 2.3 2.3 2.4 2.2 2.1 2.2 2.3 2.5 2.6 2.7 2.6

Driving Market Forces Economics 7

Deutsche Morgan Grenfell Market Issues November 3, 1997

rates recorded over the past 35 years. In Japan, the inflation rate should even fall
from 1 ¾% to under 1 ½% in 1998 – partly due to the base effect of this year's
consumption tax hike .

... risks in the USA

In the USA, where the economic upswing will be in its seventh year and growth
well above the long-term trend in 1998, there is a danger of consumer price
... whereas US inflation
inflation accelerating noticeably to an average of 3 ¼% (1997: 2 ½%). At present,
will likely rise to 3 ¼% in
it is still very moderate (2.2%). The ongoing rise in capacity utilisation and the
1998
extremely low unemployment rate compared with other countries (and thus stronger
wage growth) should, together with the recent increase in industrial raw materials
prices, lead to an acceleration in US inflation to a good 3 ½% in the fourth quarter
of next year. The risk of this forecast being too optimistic should be limited,
however, as our baseline scenario sees the Fed tightening monetary conditions
soon and continuing its aggressive course next year. We expect the Fed funds rate
to be 25 bp higher by the end of Q1. Further steps will likely follow in 1998, pushing
it to around 6.75% 12 months from now (currently 5.5%).

Wages: considerable restraint in Europe ...

In parallel with the
declining cost pressure,
the rise in consumer
prices has slowed in
Europe
The signs of recession at the beginning of the 1990s, the high level of unemployment
and the continuing globalisation of the world economy, have led to considerable
wage restraint in Europe. The rate of increase in remuneration per private-sector
employee fell from around 8 ½ % per year in the 1980s to 4 ¼% in the past six
years. This, with strong productivity growth of around 2% per year, brought the
growth of unit labour costs down to just under 1 ½% per year in the period 1991 to
1996 from 5 ½% in the preceding decade.

... reflected in inflation figures

In parallel with the declining cost pressure, the rise in consumer prices has slowed
in Europe. The EU inflation rate, around 7% per year in the 1980s, fell back to an
average of 2 ½% in 1996. This was the lowest rate for more than 35 years.

This year and next, the rate of wage growth will probably continue to slow in many
EU countries. The OECD forecasts the average increase in wage costs per employee
among the EU countries to be 3 ½% in 1997 and 3 ¼% in 1998. The largest
increase is expected in the UK (4% in 1997, 5% in 1998). The organisation
calculates the rise in unit labour costs to average 1 ¼% across the EU in both
years, which will undoubtedly keep a lid on inflation.

EU:
EU: Consumer prices
18 Wages, unit labour costs & inflation 16
% yoy % yoy
15
12
12
8
9
4
6

3 Compensation per employee 0

Unit labour costs
0 Consumer prices
-4
61 65 69 73 77 81 85 89 93 97
80 82 84 86 88 90 92 94 96 98

8 Economics Driving Market Forces

November 3, 1997 Market Issues Deutsche Morgan Grenfell

USA: at NAIRU?
In the USA, the rise in wage and unit labour costs has also slowed compared with
the 1980s, although the decline has been much less pronounced than in Europe.
Wage growth is, moreover, likely to accelerate this year and next on account of the
continued strength of economic growth and the much more favourable labour
market situation than in Europe. The unemployment rate has declined to below 5%
– unlike in Europe, where it has moved upwards in waves with the business cycles
The US unemployment (currently just under 11%) – and is currently less than the low recorded before the
rate is below the level last recession in the USA at the beginning of 1990.
which was until recently
seen as inflation-neutral... The US unemployment rate is thus below the level which was until recently seen
as inflation-neutral. This means inflation should already have accelerated markedly.
The concept of NAIRU (non-accelerating-inflation rate of unemployment) is founded
on the empirical observation that the rate of price increase accelerates when
unemployment reaches a very low level and slows when unemployment is very
high. If the unemployment rate falls below NAIRU, then labour market bottlenecks
and the beginnings of a wage/price spiral are likely to follow. The fact that inflation
has not yet accelerated as expected could possibly mean productivity growth has
been underestimated. Rationalisation, innovations and new technology, particularly
in telecommunications and data processing, have presumably led to a strong increase
in productivity which has been understated by the official statistics, as pointed out by
Fed Chairman Alan Greenspan. In view of the significant increase in corporate
earnings and margins, Greenspan believes the official figures are simply wrong.
... but NAIRU does not NAIRU not a constant
remain constant over
many business cycles. NAIRU is not, moreover, a level which remains constant over many business
cycles. In the past few years it has shifted significantly downwards. Changes in
labour market conditions brought about by political measures and demographic
developments, more flexible wage policy and altered reactions on the part of
NAIRU declined economic agents to economic policy measures are likely to have been the main
markedly due to factors behind this. If, for example, counteractive monetary policy measures are
demographic taken sufficiently early, they should curb wage growth, especially if they are
developments, changes in successful in lowering expectations of inflation or even in preventing such
labour market conditions, expectations from arising in the first place. In the 1990s, conditions in the USA
stronger competitive have changed in this way. Another factor behind the downward trend in NAIRU
pressure following could be the heightened pressure from international competition as a result of
increasing globalisation increasing globalisation, which has probably reduced the willingness of companies
and greater concern to agree to demands for higher wages. And as far as employees are concerned, job
about job security security is considered lower than in earlier business cycles in light of the changed
employment conditions (e.g. more redundancies, fewer temporary lay-offs), which
has presumably led to some moderation in wage demands despite the favourable
labour market situation.

USA: Unemployment & wages

Unemployment rates 8
12 Unemployment rate, %

EU
6
9

4
6

USA
2
3 Hourly wages, % yoy

% 0 0
85 86 89 91 93 95 97
64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96

Driving Market Forces Economics 9

Deutsche Morgan Grenfell Market Issues November 3, 1997

Our calculations, which are based on a simple Philips curve model with adaptive
inflation expectations, show that NAIRU may now have been reached. They give –
for the past 37 years – an average NAIRU of slightly more than 5 ½%. However,
when we exclude the period from 1973 to 1984, in which inflation was largely
determined by the two oil price shocks, NAIRU is found to have fallen to around 4
¾% (in the period 1984 to 1997) from just over 5% (1961 to 1972).

This explains at least in part why the strong rise in employment (by around 5.5
million in 1995 and 1996 combined and by almost 250,000 on average in the past
seven months) and the decline in the unemployment rate to, briefly, 4.8% have not
led to a significant acceleration in inflation. On the contrary, the inflation rate
declined from 3.3% at the end of last year to 2.2% in September. However, it is
barely imaginable that a further reduction in the unemployment rate or a continuation
The considerable at this low level would have no influence on the development of prices.
increase in corporate
earnings and profit The new power of the unions
margins is still absorbing The outcome of the strike at UPS and the demands of the Delta Air Lines pilots for
higher wage costs but additional improvements demonstrate the increasing capacity of the unions – in
new union power the tight labour market environment – to secure sizeable wage increases and thus
harbours the risk that correct the shifts which have taken place in the distribution of wealth to the
price pressures may disadvantage of the labour force over the past few years. The considerable increase
emerge in corporate earnings and profit margins is to some extent still absorbing higher
wage costs before they can feed through to consumer prices. But if the UPS
settlement sets a precedent for other sectors, it is unlikely that the impact of
higher wages will be borne in full by earnings with no spill-over effect on consumer
prices.

Against this backdrop, wage growth will probably accelerate. The OECD expects
wage costs per employee to rise by just over 4 ½% in both 1997 and 1998
(compared with 3 ½% per year in the past six years) and unit labour costs to increase
by 3% this year and 3 ½% in 1998 (after 2 ¾% per year from 1991 to 1996), which
should contribute to the rise we expect to see in consumer price inflation.
Whereas the US output
Output gap: closed in the USA ...
gap suggests that price
increases are in the A crucial determinant of the development of inflation in the longer term is capacity
pipeline ... utilisation in the economy. The higher the capacity utilisation, the stronger the
inflationary effect of labour market tensions in the long term.

With growth above its long-term trend in the USA, the output gap, which in the
1991 recession widened to almost 2% of GDP, will this year more than close. After
a positive gap of just over 1% of GDP in 1997, capacity utilisation could next year

USA: Unemployment rate & inflation USA:

15 Wages, unit labour costs & inflation
198 0 15
% yoy
12
Compensation per employee
81 12
Unit labour costs
9 Consumer prices
9
82
90 6
89 91 84 6
88 87 85
3
92 83
199 7 9695 94 93 86 3
0
4 5 6 7 8 9 10
Unemployment rate, % 0
80 82 84 86 88 90 92 94 96 98

10 Economics Driving Market Forces

November 3, 1997 Market Issues Deutsche Morgan Grenfell

– on the basis of our growth forecast of just over 3 ½% – be significantly more than
2% over its long-term average. This would tend to increase fundamental price
pressure in the USA.

If productivity growth has indeed been underestimated as discussed earlier, this

could suggest capacity utilisation has to some extent been overestimated. If this is
true, the US economy could expand at a rate above the trend for longer than
expected without overheating. But if productivity growth has been underestimated,
then the GDP figures are probably also too low, thus leaving the output gap
unchanged. But even assuming the rate of productivity growth in the USA is a point
higher than the official figures show and thus at roughly the European level, the
output gap would – at otherwise unchanged GDP – close in the current year and, in
1998, would be +1 ½% of GDP.

... price risks from ... but still open in Europe and Japan
capacity utilisation in Compared with the USA, the price risks from capacity utilisation in Europe and
Europe and Japan are Japan are still low. In Japan, the output gap is around 3% of GDP this year and is
still low unlikely to narrow significantly in 1998 if our GDP growth forecast of a good 1 ½%
is correct.

In Europe, we put the output gap at an average 1 ½% of GDP this year, declining in
1998 to ¾-1% on the basis of our GDP growth forecast of around 3% in the EU.
The situation varies considerably from country to country, however. While Italy has
an output gap of 3%, in Germany it is just under 2% and in the UK the gap has more
or less closed. The situation in the UK is comparable with that in the USA:
economic growth is strong and capacity utilisation should consequently be more
than 1% above its long-term average next year, which underpins our expectation of
higher inflation. In the continental European countries, on the other hand, the
existing output gaps make fundamental price pressure unlikely.

In the USA; the risk of USA: cost-push vs. demand-pull inflation

higher inflation emanates
more from the cost than
the demand side
In the USA, the risk of higher inflation emanates more from the cost than the
demand side. Although consumer spending grew by just over 2 ¾% in the first half
of this year and will probably expand by a good 3% in the year as a whole (after 2
½% in 1996), the rate of increase is much lower than in the previous business
cycle (1983 to 1990). It is also noticeable in this context that investment growth
has been much stronger in this cycle than in the preceding one, so the pick-up in
private demand has been matched by a corresponding expansion in capacity. The
main driving force is investment in machinery and equipment. Whereas real
consumer spending has risen by only 17.5% in the current cycle, compared with
more than 26% over the same timespan in the previous cycle, investment has
leaped almost 50% versus the first quarter of growth in the current cycle. In the
first 23 quarters of the last cycle the increase in investment was only 35%.

USA: Output gap & inflation Germany: Output gap & inflation
16 8
14 CPI
% yoy 6
CPI 12
% yoy 10 4
8
2
6
4 0
2
-2
0
Output gap -2 Output gap -4
(actual - potential GDP, (actual - potential GDP,
-4
% of potential GDP) % of potential GDP)
-6 -6
76 78 80 82 84 86 88 90 92 94 96 98 76 78 80 82 84 86 88 90 92 94 96 98

Driving Market Forces Economics 11

Deutsche Morgan Grenfell Market Issues November 3, 1997

In continental Europe, the fiscal drag suggests there will be no demand-pull-induced

acceleration in inflation yet. Domestic demand should pick up next year, but remain
well below a level which could fuel inflation. Growth in many countries will thus
again receive its strongest stimulus from exports next year, while consumer spending
will lag behind the rate of GDP expansion – in some countries a long way behind it.
In Germany, for example, we expect the increase in private consumption to be only
1.5% in 1998, i.e. half the rate of economic expansion.
In the long term, inflation
is a monetary Danger from too generous monetary expansion?
phenomenon Few dispute that inflation is, in the long term, a monetary phenomenon and that
the money supply therefore plays a key role in explaining it. Only in the short and
medium term can prices diverge from the path marked out for them by the
development of the money supply. In light of this, the rate of money supply growth
in some countries, which has been and in some cases still is well above the target
zones, has led to fears that inflation is about to accelerate. Prices – so the
argument runs – may follow money supply growth after a time lag. Studies
suggest a period of up to 2 years. In Germany, for example, monetary expansion
was almost 8% in 1996 (M3, vs. Q4 1995), well above the Bundesbank’s target for
that year. It did not enter the 3.5-6.5% corridor set for 1997 until this July. In the
USA, M3 money supply growth has recently been almost 8% (compared with the
target of 2-6%), and in Switzerland, the monetary base is growing more than six
times as fast as the target rate (1% in the medium term).

There have been similar deviations and comparably low inflation rates in earlier
periods. Interest and exchange rate developments have influenced demand for
It is important that money and temporarily obscured the longer-term links between the money supply
monetary expansion in and inflation, as have non-monetary inflation factors such as oil price shocks,
many countries is steered struggles over the distribution of wealth, changes in indirect taxes or long-term
back to a path consistent programmes to consolidate public finances. It is questionable, however, whether
with stability current factors are influencing demand for money in such a way that an increase in
the money supply will not lead to higher prices. This would be the case, for
example, if the larger money supply were used not only for the purchase of goods
and services but also for storing wealth. The low level of interest rates at present
and, above all, the expectation of rising yields could well lead in this direction.
However, it is also important that monetary expansion in these countries is steered
back to a path consistent with stability in good time so as to avoid endangering the
successes achieved by monetary policy this decade and to enable inflation to be
kept under control in the long term.

USA: USA:
Private consumption in the cycle 135
Investment in the cycle 155
Business cycle Present business
150
Q1 1983 to Q3 1990 130 cycle
since Q4 1991 145
125 140
135
120 130
Business cycle 125
115
Q1 1983 to Q3 1990
120
Present business 110 115
cycle
since Q4 1991 110
105
105
(Fir st quar ter of gr owt h = 100) (First quarter of growth = 100)
100 100
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31

12 Economics Driving Market Forces

November 3, 1997 Market Issues Deutsche Morgan Grenfell

Exchange rates: price risks for Europe

Not only domestic influences but also exchange rate-induced factors are exerting
opposing effects on prices in Europe and the USA. Whereas the stronger USD is
dampening US inflation, it is likely to put upward pressure on prices in Europe. The
DEM and other currencies in the DEM bloc have lost around 15% of their value
against the USD since the beginning of this year, with corresponding effects on
import prices. The impact on consumer prices should be much smaller, however:
the scope for passing higher import prices on to consumers is not particularly wide
at present since growth is weak and largely export-driven, and since on a trade-
weighted basis the European currencies have weakened to a much lesser extent.
The result of the change Against Germany’s most important trade partners, the DEM has depreciated by
in the nominal effective barely 4 ½%.
exchange rate and
imports as a proportion A rule of thumb can be used to determine roughly the size of the effects of
of GDP can be used as a exchange rate developments on consumer prices, effects which occur after a very
rule of thumb to short interval of only a few months. The maximum impact can be estimated by the
determine the effect of product of the change in the nominal effective exchange rate and imports as a
exchange rate proportion of a country’s GDP. For Germany, this gives 1.0 (4.4% depreciation of
developments on the trade-weighted exchange rate multiplied by 22% imports-to-GDP), i.e. if the full
consumer prices. change in import prices is passed on to the consumer, then inflation will rise – all
other conditions remaining unchanged – by between ¾ and 1 percentage point. In
France, the less pronounced depreciation of the FRF and the lower proportion of
imports to GDP indicate the influence would be only ½-¾ of a point. In the
Netherlands and Belgium, on the other hand, the high ratio of imports to GDP (48%
and 68% respectively) would put the effect at 2 ¼ and 2 ¾ percentage points.

These estimates should not be over-rated, however, especially as the link between
exchange rate and inflation has weakened over the past few years. They are only
intended to give an idea of the size of a possible effect. As already described, the
influence of exchange rates in the DEM bloc countries (with the exception of the
Netherlands) is counteracted by opposing domestic effects. In Germany, the only
The DBR commodity gradual recovery of the domestic economy means the scope for passing price
index, based on major increases at upstream level on to the consumer – at least next year – is very
limited, and unit labour costs should fall slightly again in 1998, albeit by less than in
the current year. We expect average inflation in Germany to be 1.8% in 1997 and
1998 respectively. Since domestic demand is stronger in the Netherlands than in
Germany, the exchange rate development suggests inflation there will accelerate
slightly to 2.7% in 1998 from 2.3% in 1997.

Germany: M3 & inflation USA: M3 & inflation

8 15 15
M3 % yoy % yoy
(shifted forward
2Y, right)
6 12 M3 12
(shifted forward
2Y)
4 9 9

2 6 6
Consumer prices
0 (left) 3 3
Consumer prices
% yoy
-2 0 0
60 64 68 72 76 80 84 88 92 96 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98

Driving Market Forces Economics 13

Deutsche Morgan Grenfell Market Issues November 3, 1997

... but relief for the USA and UK

For the USA, the rule of thumb indicates a reduction in inflation by around ¾-1
percentage point (which, alongside the effects mentioned above, helps to explain
the low level of inflation at present). For the UK, it gives a reduction of a full 5
percentage points owing to the dramatic rise in the GBP (almost 17% on a trade-
weighted basis in the first half of 1997). Since, however, it is unlikely that the relief
will be passed on in full to the consumer, the actual price-dampening effect should
be considerably smaller – yet significant nonetheless. Against this backdrop, UK
inflation has so far been disappointing. It fell to 2.5% in May (core rate, i.e.
excluding mortgage interest payments) but then rose again slightly to 2.7% in
September.

Raw materials: DBR index signals price pressure

non-ferrous metals,
precious metals and
crude oil, currently points
to price pressure
So far, analysis of the very favourable inflation situation in the USA has taken little
account of the fact that raw materials prices declined substantially in the first half
of 1997 (by around 10% measured by the HWWA index on a USD basis; by about
18% measured by the DBR-CI). The decline was mainly due to lower oil prices,
whereas the prices of other industrial raw materials continued to rise. Commodities
prices have in the past been reliable indicators of the future trend in consumer
prices. The import-weighted HWWA index correctly forecast 9 out of 13 turning
points in the US consumer price index over the past 30 years, with only four wrong
forecasts. The DBR commodity price index, which is based on the prices of the
major non-ferrous metals, precious metals and crude oil, and is calculated on a
USD basis, has probably bottomed out. We expect oil prices to stabilise in the
remaining months of this year, and precious and non-ferrous metal prices to rise
further. The overall index should thus have gained 3% by the end of this year and
climb a further 2% in 1998. Experience from earlier cycles shows that this will feed
through into an acceleration of US inflation after a delay.

For inflation in Europe, oil prices are less significant in USD than in national
currencies. The dampening effect of declining USD oil prices has been much
smaller in Europe, since the European currencies have weakened considerably
against the USD. Oil prices have been declining on an ECU basis since the beginning
of this year, but much slower than in USD, and in the past few months they have
even begun to rise again. In August ECU oil prices were more than 8% above their
pre-year level. The recently slightly weaker USD is now providing some relief here.
However, as we expect it to strengthen again, oil prices on an ECU basis should
rise until around the middle of next year and then stabilise. The expected rise in
prices for other industrial raw materials will also likely exert upward pressure on
European consumer prices.

Nominal effective exchange rates 120 DBR-Commodity price index

100
DEM
110
FRF 90
USD 100

GBP 90 80

80
70
ITL
70

1990=100 60 60
90 91 92 93 94 95 96 97 94 95 96 97 98

14 Economics Driving Market Forces

November 3, 1997 Market Issues Deutsche Morgan Grenfell

Today’s low inflation
rates are not the result of
increasing globalisation
but rather of the
responsible and stability-
oriented monetary
policies pursued in the
1990s
Conclusion
Inflation is not dead. It is not at such a low level throughout the world because the
increasing globalisation of the world economy is producing permanently low prices.
Fierce global competition means that price differentials between comparable goods and
services cannot be excessive; it does not imply that the absolute level of prices must
remain constant. The theory of the ”new” era of inflation-free growth cannot maintain
that there is now an automatic mechanism which produces price stability without
external help. The low inflation rates almost all over the world are largely the result of the
responsible and stability-oriented monetary policies pursued in these countries in the
1990s. Stability needs to be bought over and over again by a continuation of this policy.
A prime example of this is the Fed, a forward-looking central bank which, despite
US growth being significantly above potential, has so far shown considerable
restraint in its actions. Globalisation and the closer interweave of the financial
markets have probably helped it by causing a change in the monetary transmission
mechanism, in which the exchange rate now plays a more important role. The
sharp rise in the USD has made the monetary environment significantly more
restrictive, so the Fed may now need to hike key rates to a much smaller extent
than in 1994/95 to achieve its monetary policy aims. In that period, the USD lost
around 10% of its value – in the first seven months of this year it has gained almost
6%. We expect the Fed to hold back until at least the end of this year, tightening
policy in the course of 1998 when there are clearer signs of increasing price
pressure. A 25 bp hike in the Fed funds rate in the first quarter will likely be
followed by further steps. On a 12M horizon we see the Fed funds rate at 6.75%
compared with 5.50% at present.

On the other hand, the weakening of the DEM (and with it the currencies of the
DEM bloc) means that monetary conditions in Europe have eased appreciably, so
the central banks will put themselves on alert. The recent Bundesbank rate hike,
which was followed by the other EMS core countries, was a move to nip inflationary
dangers in the bud and at the same time a signal of concerted monetary policy
action in the run-up to EMU. In view of the predominantly export-driven recovery in
Europe, however, this is unlikely to herald a rapid series of further rate hikes.

Bernhard Gräf, Frankfurt, (69) 910-31738

USA: Nominal effective exchange Inflation & exchange rates

rate & fed funds rate
7.0 110
%
6.5 Appreciation (+)/ Effect on
Fed funds 105
6.0 (left) Depreciation (-) inflation rate
5.5 100 J/July 1997 Imports Percentage
5.0 % yoy * % of GDP points
4.5 95
USA 7.2 12.6 -0.9
Nominal
4.0 effective Japan -7.0 9.4 0.7
90
3.5 exchange
rate (right) Germany -4.4 22.0 1.0
3.0 85
France -3.2 21.4 0.7
J FMAM J J A S ON D J FMAMJ J A SON D
1994 1995 Italy 2.3 20.0 -0.5
7.0 110
% United Kingdom 17.5 30.0 -5.3
6.5
105 Spain -4.5 24.2 1.1
6.0 Fed funds
5.5 (left) Netherlands -4.6 48.2 2.2
100
5.0 Belgium -4.1 67.8 2.7
4.5 Nominal 95 Austria -2.1 38.7 0.8
effective
4.0 exchange 90
3.5 rate (right) * Nominal effective exchange rate
3.0 85 ** If import price changes are passed in full to consumer
J FMAMJ JA SOND J FMAMJ JA SON D
1996 1997

Driving Market Forces Economics 15

Deutsche Morgan Grenfell Market Issues November 3, 1997

Japan: BoJ’s autumn quarterly economic

outlook
The BoJ released its Quarterly Economic Outlook (autumn 1997) report at 2.30pm
on 27 October.

Tone even more pessimistic than recent comments by BoJ officials

Very sober view of the
economy Recently, the BoJ branch managers meeting and Governor Yasuo Matsushita’s
regular press conference have revealed that the BoJ has a significantly pessimistic
outlook on the economy. However, the Quarterly Economic Outlook revealed an
even more pessimistic view than suggested by recent comments by officials.

The BoJ maintains that “the recovery trend . . . has not been undermined”.
However, it is inappropriate to conclude from this that the BoJ sees the economy
as being in a recovery. Looking back over changes in the tone of comments by BoJ
officials, it is evident that the most recent statement represents a deterioration
from the Bank’s previous view that “Japan’s economy continues on a moderate
recovery trend”. The latter is how the bank expressed its view of the economy up
until the branch managers’ meeting. So the most recent outlook is by no means
positive.

Recent economic conditions: BoJ outlook has become significantly

cautious over past few months
The report states that: “Japan’s economic growth has been decelerating since
April, partly reflecting the impact of the consumption tax hike. Corporate sentiment
has also weakened somewhat. However, the recovery trend in corporate profits,
employment and income conditions has not been undermined, supported by the
rise in exports and business fixed investment.” We believe that the expression
“decelerating” reflects a significantly cautious outlook by the BoJ.

Future economic trends: BoJ noncommittal

The BoJ’s view of future economic trends is best expressed in the report’s closing
statement: “. . . the basis for economic recovery has not been undermined. If
household expenditure picks up and inventory adjustment pressures subside steadily,
the economic recovery is likely to gather momentum again, albeit gradually”. What
is significant here is that elsewhere the report says that “there are uncertainties

1990=100
%, YoY
114.0 20.0 30.0
Industrial Production
112.0
10.0 25.0
110.0

108.0 0.0 20.0

106.0
-10.0 15.0
Inventory
104.0 (%)
-20.0 Official Discount Rate 10.0
102.0

100.0 -30.0 5.0

98.0
-40.0 0.0
96.0 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98
Source : BoJ, MITI.
90 91 92 93 94 95 96 97 Note : Shaded areas indicate periods of monetary easing.
Oource : MITI. Note : Thick line is quartery data.

16 Economics Driving Market Forces

November 3, 1997 Market Issues Deutsche Morgan Grenfell

about the recovery in personal consumption”, so the BoJ is by no means confident

that inventory adjustment pressures will in fact subside thanks to a pickup in
household spending. In other words, the BoJ is saying that an easing of inventory
adjustment pressures that would result from an improvement in consumption is
important for an economic recovery, but it is not stating that it expects such a
recovery. Indeed, Masayuki Matsushima, director of the BoJ’s Research and Statistics
Department, said that: “It is inappropriate to conclude at this point in time that
there is no possibility of an economic recovery scenario being realised.” This
actually suggests that Matsushima is very aware of the possibility that the economic
recovery could fail to materalise.

The QEO also notes that the BoJ’s oft-cited virtuous cycle of increasing production,
income and expenditure is in danger of reversing, producing a vicious cycle with
reduced expenditure giving way to lower production and falling income. This
shows that the BoJ has divided its analysis of stagnating consumption along the
lines of 1) reaction to forward demand ahead of the consumption-tax hike, 2) fiscal
policy, including reduced purchasing power due to tax hikes, and 3) income factors,
such as lower purchasing power caused by falling personal income. Such phenomena
as the levelling-off of production and the slowing of corporate earnings growth
pose a real risk to personal income in accordance with point 3) above.

Asian currency and equity market meltdowns not yet factored in by the BoJ.
The BoJ also seemed to pay little attention to either the Asian equity and currency
market turmoil or the threat of asset deflation on the economy, with the report
downplaying the impact of the ASEAN crisis on Japan and suggesting that “the risk
of deflation is negligible”. The past week’s events however will have led the BoJ to
question this view. While the hit from the ASEAN crisis, which we assume to be the
equivalent of a 0.3% detraction from GDP, is not particularly alarming, as the
contagion has now threatened the rest of Asia (as well as global emerging and
developed economies) a much larger negative effect must be considered. Although
it is far too early to assess just how widespread and deep the threatened crisis may
be, certainly the risk to Japanese growth from the loss of competitiveness of
Japanese exports from a pan-Asian currency slump which excludes the yen, and
the dampening effects of weaker Asian growth rates, would be considerable.
Exports to the ASEAN 4 equates to around 12.5% of Japanese exports, but the all-
Asia market is nearer 45.0% of global exports, suggesting that a pan-Asia crisis
could easily knock over 1.0% off GDP.

Aside from the loss of net-export contributions to growth, the other key unknown
stems from the risks to the banking system from the sharp rise in potential bad-
loans to both domestic and Asian firms and the exposure to property risk.
Domestically, the recent fall in the Nikkei has already sharply reduced the profitability
of Japanese banks with a recent Nikkei article suggesting that interim 1 H FY97
valuation losses recorded on bank, security company and construction firm shares
by the top 20 banks topped JPY 2.5 tr, and the unrealised stock market profits
available to these banks slumped from JPY 8.0 tr to just JPY 3.8 tr. Since 2H FY97
began, the Nikkei has plunged further, from around 18,000 in late September to
almost 16,000 in late October. Any substantial move below the 16,000 threshold
would certainly have serious ramifications for some of the top 20 banks, whose
level of unrealised equity profits may have already been exhausted. Japanese
bank’s risk from exposure to the Asian crisis is also of concern, with Japan providing
almost USD 300 bn worth of loans to Asian last year, and some 42% of all loans
made for example to Hong Kong (50% of which is tied to real estate).

The additional burden of rising bad loan costs from overseas at a time of domestic
financial difficulties is clearly something that the Japanese authorities will want to
avoid at all costs. While the serious threat of systemic risk impacting the wider real
economy seems still some way off, in the wake of the past weeks equity and

Driving Market Forces Economics 17

Deutsche Morgan Grenfell Market Issues November 3, 1997

currency turmoil, the BoJ cannot afford to be complacent. A further cut in the ODR
would of course have little effect but may be considered as a short term emergency
measure, if a further meltdown in the equity market appeared to be unfolding. The
focus however should remain on fiscal rather than monetary policy, with the likely
determinate of the equity market and the domestic growth prospects for next year
largely dependent on whether or not the Hashimoto government is willing to
sponsor a serious round of fiscal stimulus measures for both the corporate and
personal sectors.

Katsuyuki Shibayama, Tokyo, (813) 5401-7276, Peter Frank, London, (171) 545-1163

18 Economics Driving Market Forces

November 3, 1997 Market Issues Deutsche Morgan Grenfell

Banking on higher rates

Bank put rates on hold in
August...
...to assess the risks...
...which we feel call for
higher rates
Some argue that growth
is slowing...
...a view reflected in the
market’s rate
expectations
The fundamentals
though remain strong
Wages and salaries are
growing rapidly...
...unemployment
continues to decline...
“Given those uncertainties, the MPC concluded that monetary policy has now
reached a position at which it should be possible to pause in order to assess the
direction in which the risks are likely to materialise.” Those were the final words
in the Bank of England’s August Inflation Report, published a week after they last
raised interest rates, from 6.75% to 7%. Since then, the Bank has indeed kept
policy on hold, while continuing to note of the “upside risks” to inflation going
forward. The important issue for the markets, one week before the next monetary
meeting, is whether the Bank now feels the risks have sufficiently crystallised to
justify a further increase in rates. We believe they have and, in addition, continue
to look for a peak of 8% in rates next year.
However, some commentators have argued that various economic indicators
point to a slowdown going forward, implying that base rates should be left on hold.
A common argument is that the strong growth seen over the summer was fuelled
by hedonistic windfall spending; now that this is easing, the 100bp rise in short
rates and overvalued level of sterling should drag growth back to trend. The short
sterling curve expects at worst one more rate rise in the next few months, before
rates gradually head lower next year Such prognostications are based on weaker
retail sales growth, a slowdown in the housing market, signs of a moderation in
service activity and continued sluggishness in manufacturing. However, we do not
subscribe to this view. While growth may have peaked and no longer be accelerating,
it remains well above trend, as evidenced in the Q3 GDP report, and there exists
little evidence that the inflation target will be met.
The analysis must start at the consumer level. Is it fair to say that the pick up in
retail sales growth over the summer was entirely driven by windfall-related spending
which, by its very nature must be transitory? The short answer is no. Consumption
growth mainly depends on the fundamental drivers: employment, real incomes,
confidence and the housing market. None of these are yet showing signs of
sustained slowdown. Indeed, in the second quarter, real personal disposable
income was 4.2% higher than a year earlier. Perhaps more importantly, wages and
salaries were an encouraging 6.4% above last year’s level. With signs that wage
settlements are picking up in response to a tighter labour market, real income
growth is unlikely to dissipate just yet.
The labour market is also grounds for optimism. Although the decline in
unemployment in September was below expectations, the longer the recovery
continues, the more likely that the pace of falls in unemployment will slow.
Unemployment has fallen by 600,000 in the last 12 months, and employment
trends remain strong, particularly in the service sector. Indeed, the British Chambers

Growth remains strong... . ..and buoyant money supply...

6 6 20 % yoy 20
GDP % yoy Consumer credit
Consumption % yoy Broad money growth
5 5
15 15

4 4
10 10
3 3

5 5
2 2

1 1 0 0
1994 1995 1996 1997 1990 1991 1992 1993 1994 1995 1996 1997

Driving Market Forces Economics 19

Deutsche Morgan Grenfell Market Issues November 3, 1997

...with service sector
employment intentions
especially strong...
of Commerce (BCC) stated that “the proportion of service sector firms (in Q3)
trying to recruit matched the record level reported last quarter”. Even in the
underperforming manufacturing sector, skill shortages as a constraint on labour
have risen above the long-term average. Given that many of the long-term
unemployed are, through atrophying of skills and benefit dependency, “outsiders”
in the labour market, the effective pool of labour may not be that large. These
statistics are hardly representative of a rapidly decelerating economy.

...and skills shortages
rising as labour market
tightens
So outlook for
consumption is good...
...and windfall spending
is NOT over...
...although retail sales
growth may edge down
after summer froth
Housing market is also
key
The market was
artificially boosted in the
summer...
...but the level of activity
remains encouraging...
The above two factors should underpin consumption growth in coming quarters.
Moreover, it is far from clear that we have yet benefited from the full impact of the
windfall gains. Even in September, car sales were 16% higher than a year earlier,
after a record August. The Bank of England estimated that the latest MORI survey
on windfalls translated into additional consumption of some GBP 6 bn, and that this
was a lower bound. This does not suggest a strong case for a weak consumer
sector. The September data is so distorted by the funeral of the Princess of Wales
and unseasonably warm weather that it is useless as a barometer of the economy.
What is more encouraging is that with the return of more seasonal weather,
retailers are reporting more buoyant conditions. Accordingly, it is unrealistic to
claim that the unwinding of frothy consumer activity over the summer is
representative of a sustained consumer slowdown. In addition to the above signs
of consumer buoyancy, it is worth noting that the GfK consumer confidence
barometer continues to register levels not seen since the late 1980s boom.
Moreover, the housing market profile in recent months has also been distorted.
Turnover growth has slowed from around 30% to 15% currently. Net new
commitments, a useful guide to future activity, have been broadly flat in recent
months. There is however good reason to believe that worries around the election
and in the run up to the (it was feared tax-raising) July Budget led to a temporary rise
in activity. As a result we may have seen unsustainable sharp increases in house
prices in certain areas, notably London and the South-East. As the market settles
down after the pre-Budget flurry it is reasonable to expect some deceleration in the
activity indices mentioned above. The important points are that not only are the
levels of housing market lending and turnover at the highest for some years but that
houses remain undervalued relative to earnings, historically a useful indicator of
continued buoyancy in the housing market. The provision of highly attractive
mortgage deals, particularly fixed-rate, also lessens the effect of the recent 100bp
rise in short rates. We remain confident that house price inflation will be strong in
coming quarters and that housing market turnover will fuel overall economic activity.
Thus far, the argument we are pursuing runs along the lines that while growth
does seem to have eased slightly from a very strong level, it remains robust and
well above trend. This is supported by evidence from the service and, perhaps

...and earnings are inflation risks... ...which call for higher rates.
25 10 16 16
Vacancies, % unemployment (lhs) forecast
Average earnings % yoy (rhs) 9
20 14 14
8
12 12
15 7
6 10 10
10 5
8 8
4
5 6 6
3 %

0 2 4 4
1991 1992 1993 1994 1995 1996 1997 1990 1991 1992 1993 1994 1995 1996 1997 1998

20 Economics Driving Market Forces

November 3, 1997
...and we expect a
renewed pick-up.
So growth is not slowing
fast...
...with the service sector
notably upbeat...
...in both the survey and
actual data.
Moreover, manufacturing
is holding up...
...with orders and output
above average levels...
...reinforced by strong
output in Q3.
So while growth may not
be accelerating...
...a return to trend is not
obvious...
...placing pressure on
inflation
Money supply remains a
concern for the Bank...
...and is showing no signs
of slowing
Labour market
tightness...
...is pushing up earnings
growth...
Driving Market Forces
Market Issues Deutsche Morgan Grenfell
surprisingly, the manufacturing sector. However, the recently weak Purchasing
Managers’ service survey is somewhat suspect since it short incumbency means
no track record has yet been established, although still the balances recorded were
above the neutral 50 level, indicating continued expansion. The British Chambers
of Commerce survey has yet to show any signs of sustained weakness in services.
Domestic orders and deliveries in Q3 were only slightly below the peak levels
recorded earlier this year and remain well above trend levels. This accords with the
actual data where service sector growth was a still healthy 1% in Q3, 4.9% higher
than a year earlier, weaker than both Q1 and Q2 but remaining at an uncomfortably
high level in terms of meeting the inflation target going forward.
The manufacturing survey and data evidence is also robust. The CBI quarterly
industrial trends survey recorded a rise in both domestic and export optimism.
While orders and output in the export sector remained weak, they are no longer
deteriorating, perhaps a reflection that sterling has fallen from its highs. As has
been the case for some time though, growth is stemming from the domestic side.
This can be seen from the October monthly readings where the total order book
balance was only -2 while that for export orders was -33 (although this troughed at
-37 in August). The expected output balance is robust at +20, double the trend
level and is suggestive of trend growth for the sector as a whole. The September
Purchasing Managers’ report supported this optimistic view of manufacturing with
a sharp rise in new orders and output. Indeed, manufacturing output rose by
around 0.7% in the third quarter.
Summing up, we believe that a general overview of the real economy data may
indicate a mild slowdown from the strong growth seen in recent months, but it
most certainly does not herald a deceleration in growth towards trend. This brings
us to the crux of the matter. Having raised rates by 100bp in the four months up
to August, will the Bank’s Monetary Policy Committee be satisfied with the
tentative signs of a slowdown from the excessive growth of the summer or will
the fact that growth remains strongly above trend cause them to tighten further?
It is of course worth noting that the economy is generally accepted to be at or
above full capacity. Fortunately, the August Inflation Report contains some useful
pointers, namely the upside risks to the central inflation projection. The main two
the Bank noted were M4 money supply and credit expansion and average earnings.
When the last Inflation Report was published, the Bank warned that with broad
money growth around 9% in real terms “unless that growth rate declines, possibly
in response to the policy tightening that has occurred, or there is a large fall in
velocity, demand and output are unlikely to moderate in line with the central
projection”. The latest data for September shows M4 money supply growth at
11.8%, or still around 9% in real terms. M4 lending growth has moderated slightly
with the three month annualised rate currently 6.4%, but this is unlikely to be
sustained, especially as mortgage related lending should pick up again in coming
months, and presents an upside risk to the Bank’s inflation projection.
Perhaps even more importantly are recent developments in the labour market. We
are starting to see rising wage pressures in response to excess labour demand. For
a start, average earnings growth has risen to 4.5% from 4.25% in August. Some
have argued that since this was driven by the construction sector it is not representative
of a widespread rise in earnings pressure. However, looking at the actual (as
opposed to underlying) earnings data we can see an effect. Service sector earnings
growth has risen to 4.7%, the highest since the temporary bonus-led increases
earlier this year. In the last Report, written when earnings growth was 4.25%, the
Bank warned that “further rises would take earnings growth above the level consistent
with the inflation target in the medium term”. Given that there is a strong possibility
that earnings growth rises to 4.75% in the next month or two, the Bank are likely to
err on the side of caution and moves rates higher as a pre-emptive strike. Moreover,
we expect this pressure on earnings growth to be sustained with the extent of
Economics 21
Deutsche Morgan Grenfell
...to a level inconsistent
with the inflation target
With wage settlements
heading higher...
...earnings will remain a
problem
Moreover, inflation has
(again) overshot the
Bank’s forecast...
...and stubbornly refuses
to fall in line with
upstream prices...
...which should unwind
next year
So, the BoE cannot be
content with the inflation
outlook...
...and their upside risks
have undoubtedly
materialised.
UK equity market fall has
not been enough to dent
growth...
...but market volatility
could delay rate rise until
December
Inflation risks point to 8%
base rates...
...a task given greater
incentive for the BoE by
the need for EMU
convergence
22
Market Issues November 3, 1997
labour market shortages. With headline RPI inflation having risen to 3.5% (and
expected to rise further in coming months), it is being reported that many wage
settlements are edging higher in response to an RPI-plus formula.. Thus we expect
earnings growth will also remain an upside risk for the Bank going forward and is
likely to be a fundamental factor in a further tightening in monetary policy.
Importantly, inflation has failed to meet the expectations outlined by the Bank in
August. Then they stated that “any remaining effect from the exchange rate
appreciation is likely to appear quite quickly”. This was arguably a major factor
behind their forecast of a steady decline in RPIX inflation towards 2% by mid-1998.
As it happens, RPIX inflation has refused to decline and, at 2.7%, is no lower than
it was in June. RPIX inflation may fall modestly in coming months, but it is unlikely
to fall below the 2.5% inflation target. Given the expected profile of wage
settlements and the lack of spare capacity in the economy, this must be cause for
concern for the Bank of England. Additionally, as we detail in Financial Indicators
and Monetary Policy, we expect sterling to gradually depreciate over the next year,
pressuring producer prices. In fact, a lower level of the currency is a key factor in
our forecast of a peak of 8% base rates.
Thus, the Bank of England meet on November 5-6 against the background of an
economy at or above capacity, with growth off its peak but still well above trend,
and price pressures are arguably already rising. In order to leave monetary policy
on hold, the Monetary Policy Committee has to be confident that growth is already
slowing to a trend rate sufficiently quickly to avoid upwards pressure on inflation.
This is far from the case currently. Even assuming that the windfalls have already
had the full impact on the economy (a racy assumption) domestic demand has
enough momentum to keep growth above trend for several quarters yet. With the
upside risks in the last Inflation Report having materialised, it seems to us that the
Bank have enough evidence to raise rates further.
However, we must acknowledge the recent movements in world equity markets.
While we had expected a move at the November 5-6 meeting, this has been
thrown into doubt by the recent turmoil in the stock markets. Mervyn King, a
deputy governor of the Bank, said last week that the moves were “clearly an
important component” and that “it’s something we’ll discuss at length”. At the
time of writing the FTSE All-Share is 9% down on its peak in early October, but still
20% higher than the average in 1996. Moreover, the majority of UK share
ownership is through institutional funds, as opposed to direct holdings: the effect
on confidence should thus be muted, and indeed is unlikely to alter the current
robust growth outlook. Nevertheless, the volatility and fragility of the financial
markets could cause the Bank to hold fire for one month; much will depend on
whether the markets stabilise in the run up to the meeting.
Beyond the next 25 basis points, the Bank do risk falling behind the curve if wage
settlements head higher, fuelling inflation pressures. Nevertheless, it is unrealistic to
expect the MPC to move until the risks are clearer. As growth and consumer
spending continues to come in strong, we still expect base rates to head higher, to
8% by Q2 1998. Indeed, as a footnote, the government’s wish to producer greater
convergence between the UK and European economies gives the Bank an added
incentive to dampen price pressures. The Treasury’s briefing paper on the current
state of convergence notes that “it remains to be seen whether the historical
problem of recurrent cycles of wage inflation and unemployment has been addressed”.
Applying the brakes over the next six months could well ensure that the UK does not
fall into the usual wage-price spiral. Moreover, the Chancellor suggested that the he
“would hope to lower the inflation target” in the future as part and parcel of
converging with Europe. Best make sure the present one is attained first.
Ciarán Barr, London, (171) 545-2088
Economics Driving Market Forces
November 3, 1997 Market Issues Deutsche Morgan Grenfell

Notes

Driving Market Forces Economics 23

Deutsche Morgan Grenfell Market Issues November 3, 1997

8.7
5.4
-1.4

1.2

0.0
-1.0

3.0
10Y

12.4

13.1
-1.0

-2.2
3.1

2.2
-0.9

7.9

3.9

5.2
15.6
-5.2

-3.7

3.3
0.5

-1.8

-3.8

-5.1

-5.0
-2.4
6.9

10.6
5Y
-4.6

-0.5

-2.5
1.7

0.9

10.9
2.7
in JPY

-4.0

-3.2

-3.5
-3.2

-4.5

-4.0

-4.5
-1.2
-3.9
-4.7

-1.8
-1.2

-2.5
0.3

8.2
Cash

3.8

8.4
1.3
39.7
12.7

11.3
25.3

26.7

20.6

24.3
24.0
3.9
-7.3

13.8
-15.5
30.1

16.9

18.7
Equity

15.5

19.8
36.3
12.9

10.2
16.3
6.0

5.6

8.3

7.1
6.0
6.0

4.7
10.3

21.0
10Y

20.3

9.4
15.5

11.2

23.8
12.6

-12.3

-8.1
-2.8
JPY

4.7
5Y
2.1

1.4

5.1

2.9
3.1
1.6

1.7

18.4
4.5
7.6

14.4

4.3
6.5

10.6

18.7
8.8

8.0

10.0

-6.1

-1.6
USD DEM

4.1

12.1
in DEM

-15.4
-6.2
-11.4
1.0
15.8
2.9

2.7

3.6

2.2
3.6
2.8

2.2
3.2
11.1
2.0
Cash

5.0
5.8

16.1
5.8

4.4
7.4

8.4

Commodities
27.0
11.2

20.6

34.1

35.6
19.1
29.0

33.0
23.6

49.6
-0.8
Equity

28.2
21.8
32.7

39.3

25.1
-9.5

45.8

Silver
Gold

CRB
Oil
-2.4

-3.5

-4.5

-5.7
-0.7
-4.4

-4.9

-4.5
-0.6

-1.4

9.1
8.4
1.7

11.5
10Y

4.0

0.2
4.8

1.5

6.7
-3.0

-5.8
3.1
-5.3

-7.3

-8.5

-8.4

7.0
-8.0

-8.6

-7.1
5Y

-4.0

-6.0
-1.9

-2.6
-0.3

-0.9
in USD

-7.0
-8.1

-6.7

-7.9

-7.4

-7.9
-7.3

-7.4

-4.7

-6.7

-5.3
-4.7

-5.9

-2.3
-3.3

4.3
0.1

4.6
Cash

34.8
20.9

22.2

16.3

19.9
-10.6

19.6

25.5

12.7
0.2

8.7

7.3

9.7
31.4

14.5
Equity

11.4

15.5
-18.5
15.6

11.9
6.1

5.7

5.3
7.8

7.6

6.0
15.3

5.2

11.5
7.8
8.0

9.1
5.2

-2.1
10Y

11.4

12.6

8.6
ECU

4.8
7.6
8.7
in local currencies

-9.0
GBP

-2.6
2.1
10.2
1.5

2.4
4.6

3.4

1.6

2.2

2.8
4.2

6.1
8.7

8.3
6.0

2.7
8.0
6.7
5Y

0.9
3.3

relative changes since January 1, 1997

-6.6
JPY
2.9

2.8

2.9
3.1

2.7

2.8

2.7

3.5
3.5

4.8
5.6

4.6

1.2
Equity Cash

2.9

5.6
4.3
4.5

3.7
0.3
Global Market Performance
January 1 to October 31, 1997

11.2

20.8

18.3
33.5

36.3

29.0

33.8

20.0
29.9

51.8
39.1

25.4

36.2

USD
-9.9
14.5

United Kingdom 16.6

14.5
-15.5
1.7

Netherlands

Switzerland

Currencies
against
Germany
Denmark
Australia

Portugal
Belgium

Sweden
Canada

Finland
Austria

France

Japan

Spain

DEM
USA

USD
ECU

Italy

GBP
JPY

Deutsche Morgan Grenfell

© 1997. Publisher: DB Research in Deutsche Bank AG, P.O. Box 10 06 11, D-60006 Frankfurt am Main, Federal Republic of Germany (published by the author).
All rights reserved. Please cite source when quoting.
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24 Driving Market Forces
ISSN 1430-743X