Hole In The Wall…

The data flow in the U.S. and Europe continued to give bad surprises in the week behind. The week started in a depressed mood with the prolonged repercussions of the jobless claims that had jumped to 500K the week before, while the dismal data continued to hit the prospects regarding the pace of growth with the U.S. July home sales dipping to the lowest level of the last 15 years and PMIs in the Eurozone, which had posted a surprisingly high growth in Q2, deteriorating in August. The dismal outlook pushed the stock markets lower to test their weak levels suffered in the beginning of July amidst the EU debt crisis, while the long term bond yields headed towards their historic lows. In due course, markets were all ears for Fed Chairman Bernanke’s speech in Jackson Hole conference, wondering the possible monetary policy measures that could be taken in the “unusually uncertain” economic outlook, as he describes.

Recall that in testimony to U.S. Congress in July, Fed Chairman Bernanke had outlined several options available to Fed if the “recovery seems faltering”: 1) Further changes or modifications to their language on interest rate strategy, 2) lowering the interest rate they pay on excess reserves and 3) changes in their balance sheet - either not letting securities run off or making additional purchases. In August FOMC meeting, the Fed introduced the third option by announcing that the Federal Reserve's holdings of securities would be kept constant at their current level and this decision paved the idea that the Fed sees the economic recovery as faltering. The chance of further expansion in quantitative easing, i.e. enlarging the Fed’s holding of securities, is believed to be more likely nowadays. However, at the same time, there are signs that even the Fed’s decision to keep the portfolio size constant rather than letting it diminish was a close call, with a higher-than-expected number of FOMC members opposing the idea. Accordingly, there is a challenging period ahead for Bernanke, since he has to fine tune the Fed’s policy action by taking into account that aggressive steps may fuel the panic even further while on the other hand, a less assertive position may fail to break the negative feedback loop.

We have been long emphasizing that the economic recovery would be very gradual and extended through time, considering that the housing sector and labor market took big hits from the recession. However, we consistently argue that even though we envisage a slowdown in economic activity this would not turn into a double dip thanks to the fast rebound enjoyed in global trade, as well as the relatively more robust outlooks of the most manufacturing sectors. Moreover, the manufacturers are cautious and reluctant to build up much inventory this time due to the sluggish nature of recovery, thus eliminating the chance of being caught by lofty stocks amidst periods of sudden decline in demand. Neither the leading indicators such as PMIs, nor the shape of the yield curves (accepted to be harbinger of recession when negatively sloped) suggest that the economy would head into a recession in the near future. Nevertheless, if the sell-off pressure and the market volatility remain for a long time, this may weaken consumer and business confidence, eventually transforming the current slowdown into contraction.

Meanwhile, the fresh data on domestic economic activity also suggested slowdown in economic activity. Capacity utilization rate in August rose by 5.2 pp y/y to 73.4%, which is worse than the market consensus for 74.1%. The seasonally adjusted index that we calculate edged down by 0.1 pp m/m to 73.0%. The index has been hovering at around 73% since April and hints that after gaining steam in the beginning of the year, the economic activity can barely hold gains, without any progress. Meanwhile, the RSCI dropped to 111.0 in August, with 1.7 pp m/m decrease. Nevertheless, the current level is much higher than the critical threshold of 100, which separates the expansion and contraction periods in the economy and therefore it is consistent with ongoing growth, albeit at a slower pace. The index is some 7.8 pp lower than its recent peak at 118.8, 4 months ago. The limited revival in the capacity utilization rate and Real Sector Confidence Index in July is not sustained in August, the fresh data showed. The leading activity indicators point that the recovery continues at a sluggish pace, without gaining any momentum. This outlook is in line with the global trends and fits into the trajectory envisaged by the Central Bank. Accordingly, the data supports the base scenario where interest rates remain low for more going forward. However, if the recent downbeat data regarding the global economy deteriorates even further, this would have the risk of slowing the already fragile domestic economy beyond expectations. Note that in the Inflation Report, the Central Bank assumed to resume rate cuts in such a scenario.

On the other hand, there were also fresh statements about the fiscal discipline and budget performance within the week behind. Both the comments by Finance Minister and Deputy Minister in charge of economy indicated that the budget deficit would end the year in line with the Medium Term Plan (MTP), which had put the target at 4.9%. We had previously argued that a better-than-target balance would have been the natural result of the (likely) significant upward revision in the 3.5% GDP growth, as well as the robust fiscal performance in 1H this year. (Please see August 16th). Therefore, if the realizations turned out to be close to the target, this would have been a signal of dismal budget performance in 2H. Deputy Minister Babacan said both the revenues and expenditures surface above the presumed levels, hinting that the robust revenue performance is used to finance above-forecast expenditures. Even though Babacan was the most dedicative advocate of the fiscal rule in the government, he chose to remain silent against the questions by saying that he will not make any comment on fiscal rule for a while. Therefore, the fiscal bill seems less likely to come to the agenda when the Parliament convenes in October, while it is also uncertain whether the rule would be applied to the following years.

In conclusion, the string of dismal data flow in developed countries hits recovery prospects and urges markets to demand more from monetary policy. However, the monetary authorities should balance their decisions in a way to fine tune between being more aggressive than the market expects and failing to give less than the market hopes. In due course, the data disclosures regarding the domestic economy assure the ongoing slowdown in growth rate and support the current monetary policy stance. However, if the recent downbeat data regarding the global economy deteriorates even further, the Bank may revisit their strategy. Meanwhile, there are growing signs that the fiscal policy would not give the expected support to the monetary policy.