Weekly Bank Research Center 09-15-08


US Budget and Treasury Financing Outlook: Not a Pretty Picture, but Manageable

Stephen Roach, Head Economist, Morgan Stanley

The US budget deficit is headed higher – even before considering the impact of the GSE rescue plan. In F2008, which comes to an end this month, we estimate that the deficit will be US$420 billion (or 2.9% of GDP). This is up from US$162 billion in F2007. The big swing factors over the past year were the fiscal stimulus package and macroeconomic factors which led to a slowdown in tax collections from individuals and corporations. Also, defense spending rose at a more rapid pace than in prior years. The outlook for the budget deficit over the next couple of years seems even more uncertain than usual due to a deteriorating US economy and looming political changes. Moreover, a new potential swing factor emerged over the weekend. The GSE rescue plan is almost certain to contribute to a larger near-term budget deficit. However, while the extent of the impact is uncertain, we suspect that it will be smaller than seems to be currently assumed by many market participants. In particular, we believe that there is a great deal of confusion surrounding one particular aspect of the plan – the US$200 billion of potential preferred stock purchases. We have come across some media reports that leave the impression that these funds have already been committed or soon will be. In fact, we see a relatively low probability that any purchases will occur in the near term, and even over the longer run, the amounts involved are likely to be relatively modest. This reflects the fact that the purchases are only triggered if the value of the enterprises’ assets falls below that of their liabilities using GAAP. The CBO recently estimated that the GSEs had combined GAAP-based net worth of US$55 billion. Thus, even if mortgage defaults continue to rise, it will take some time to work through this capital base.


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Inflation Decreasing in Euroland

Niels-Henrik Bjørn Sørensen, Senior Analyst, Danske Bank

The past week has been relatively quiet, with only a few new numbers for the Euroland economy. Most importantly, industrial production fell by "just" 0.3% m/m due to a relatively strong figure for France (increase of 1.2% m/m). The coming week will also be rather quiet. Final inflation figures for August are due on Tuesday, and we expect these to confirm the preliminary estimate of 3.8% y/y. Figures for core inflation will be released at the same time. So far core inflation has been contained around 1.7% y/y, and we expect it to remain so this time around. Over the next six months, though, we expect core inflation to climb gradually in response to the earlier increases in commodity prices, including oil.


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Pricing Lemons In A Sweet Tea World

E. Silvia, Ph.D. Chief Economist, Wachovia

Investors have no tolerance for risk (lemons). Unless a deal is sweet tea they won’t come to the table. As stated in our weekly of August 29th, “There is no easy out for creditors or debtors in our outlook. A difficult workout remains ahead. Capital markets continue to search for a new risk/reward tradeoff.” In 2001, George Akerlof et al. won a Nobel Prize in Economics for their description on how the interaction between quality heterogeneity and asymmetric information can lead to the disappearance of a market where guarantees are indefinite. In this model, as quality is indistinguishable beforehand by the buyer (due to the asymmetry of information), incentives exist for the seller to pass off low- quality goods (lemons) as higher-quality ones (sweet tea). The buyer, however, takes this incentive into consideration, and takes the quality of the goods to be uncertain. Only the average quality of the goods will be considered, with the side effect that goods that are above average quality will be driven from the market. This mechanism is repeated until a no-trade equilibrium is reached. As a consequence of the mechanism described in Akerlof’s paper, markets may fail to exist altogether in situations involving quality uncertainty.

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Trade Tides Very Slowly Shifting

Steve Chan, Economist, TD Bank Financial Group

Nonetheless, there were some economic data of note. International trade positions were reported to have weakened in the month of July for both Canada and the U.S. Canada’s trade surplus shrank more than expected, to $4.9 billion from $5.6 billion in June. Behind the shrinking surplus were export values that climbed by 2.2% (0.7% in volume) while imports surged by 4.6% (3.2% in volume). After declining for 3 out of the previous 4 months, the increase in export volumes is welcome. Furthermore, export values were not propped up by crude oil prices as in months prior, but stemmed mainly from machinery & equipment (+6.6%), industrial goods & materials (+5.0%) led by shipments of nickel and fertilizers. On the import side, Canadians’ increased purchasing power abroad and appetite for imported vehicles was evident as automotive product imports climbed 9.5%.

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Are Economic Growth Forecasts Any Use?

Trevor Williams, Chief Economist at Lloyds TSB Financial Markets

There is a lot of attention being placed on economic growth forecasts at present, not surprisingly since growth is slowing sharply and policy makers, companies and individuals want an idea of what is going to happen next so that they can plan ahead. We have looked at forecasts of economic growth in the UK, US and Germany (as a proxy for the Eurozone) for the last decade. The results show that great care should be taken in using, and interpreting, economic growth forecasts. For instance, it is shown that the consensus forecast, which is judged more accurate than the individual forecasts that make it up, is rarely, if ever, actually spot on. In fact, for the period 1999 to 2007 (we estimate 2008), for the three countries assessed in this analysis, the consensus did not accurately predict the actual outcome once. Charts a to c show that forecasters were close some of the time but tended to be wrong all of the time. For the UK, see chart a, forecasters tended to consistently underestimate actual gdp growth (i.e. they are pessimistic), with the outturn being more often above the forecast line than not. For the US, the opposite was true, forecasters tended to keep overestimating growth (i.e. they are optimistic). Germany was a mixture of the US and the UK. This is not to say that individual forecasts were not correct (we did not look at them all), but the same forecaster rarely gets it right consistently, otherwise everyone would tend to follow that forecaster and the consensus estimate would improve. So, if, as our analysis shows, this is not the value of gdp forecasts, what is? That seems to be in getting the direction of the change in economic growth right and, by implication, the analysis of the reasons for this.

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