Monday, April 04, 2011

Focus On Some Risk Scenarios Written By BNP Paribas

Economists at BNP Paribas presented their latest Global Outlook, entitled "Struggling with Inflation", today. Here is the excerpt from the risk scenarios:

Under our base case, to which we apportion a 60% probability, we assume that global growth remains robust at 4% or above over the coming years. We expect emerging markets to grow significantly faster than the advanced economies where growth is expected to be modest.

Global overheating (20% probability)

Policy conditions globally are accommodative. Financial and monetary conditions are looser than average in most economies and considerably looser than average in some cases. In emerging markets, particularly Asia and Latin America, conditions are looser than they should be – especially where economies are operating with the unemployment rate below the NAIRU. Hence, geopolitical events and adverse weather aside, it is not entirely surprising that commodity prices have been rising, with a resultant increase in headline inflation nearly everywhere.

Against this background, there is a risk that growth is much stronger than assumed in our central case. With PMI surveys in a number of developed economies close to 60, and little in the way of policy tightening being delivered, there is a risk of overheating. Such overheating could be fuelled by firms putting to work the stockpiles of cash that have built up due to uncertainty about future demand.

In this scenario, accelerating inflation is likely to become a greater concern. In most cases, the likely further narrowing in output gaps and lower unemployment rates would help to propel inflation higher. Moreover, the reduction of economic slack would facilitate a greater pass-through of commodity price increases into underlying inflation. A USD 10/bbl higher profile for oil prices relative to our base case would reinforce a higher path for headline inflation.

Increased inflation fears, combined with above-trend GDP growth rates, would bring forward policy normalisation. The ECB is already on the path towards tightening. This scenario would probably involve a steeper trajectory for the refi rate. Attention would also turn to the question of when the Fed and others begin to reverse asset purchases.

MENA tensions escalate (10% probability)

Social unrest in the MENA area has reinforced the upward trend in crude oil prices. There is a risk that the tensions spread to other countries in the region and threaten the supply of oil from bigger producers. In such a scenario, the price of crude oil could spike up to USD 180/bbl.

Such a spike in the oil price would probably result in stagflation. A typical rule of thumb suggests that it would cause the level of GDP to be 3.5% below the profile in the base forecast primarily as a result of a far greater squeeze on profit margins and households’ real incomes.

Similarly, headline inflation is likely to be around 2½pp higher than in our base case forecasts.

The response of monetary policy in this scenario would depend on the individual central banks. We assume that the Fed would leave interest rates on hold at current levels as the economy slips back into recession and there is a renewed increase in unemployment that outweighs concerns over inflation. Nonetheless, with inflation approaching 5% y/y, it is unlikely that the Fed would engage in additional quantitative easing.

Meanwhile, the ECB is likely to have already begun to raise the refi rate. We assume that, in the early stages, the ECB would probably tighten a little further in the face of the worsening inflation outlook. However, towards the end of the year, falls in GDP would probably bring the rate-hiking cycle to a halt.

Global slowdown (10% probability)

There are several possible catalysts for a scenario whereby growth surprises to the downside relative to our base case.

In particular, the surge in commodity prices and other costs is imposing an increased burden on households and businesses. In many cases, real household incomes are being squeezed as employment and wage inflation fall short of consumer price inflation. Similarly, producer output prices are rising far slower than input costs. That is squeezing profit margins, reducing the willingness to hire and to invest.

Although survey indicators are at, or close to, record highs, there is a danger that their ascent has been based on policy accommodation delivered over the last two years, which is coming to an end. In the absence of self-sustaining momentum, and given the continued overhang of restrictive credit conditions, it is possible that growth slips back below trend.

Events in Japan in recent weeks have highlighted the vulnerability of the global recovery to an adverse shock. The abrupt shift in sentiment and markets is an illustration of how quickly a downward shock can spread. A fall in sentiment indicators and equity markets in response to a shock is likely to hold back hiring and investment intentions as well as personal consumption.

A global slowdown would slow or even reverse the narrowing in output gaps in developed economies. In addition, a deterioration in global growth prospects would take some of the heat out of commodity prices. Both would mean a lower trajectory for headline and core inflation.

With regards to policy, a slowdown in the pace of growth to below that consistent with job creation means that the Fed would continue to fail to meet its dual mandate. In turn, that is likely to push back the timing of the first interest rate hike. It could even reignite speculation about QE3 if there are signs of disinflation.

The ECB is likely to have already started to raise the refi rate by the time a slowdown became apparent. However, as GDP ground to a virtual standstill, and upstream price indicators fell back, it is likely that the hiking cycle would come to an abrupt end.

So, quite risky with 10% probability for global slowdown?

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