(The Insider Stories) – London-based research provider Capital Economics notes that while the Fed is in no hurry to begin tapering its QE asset purchases, it is laying the groundwork for the change, and says that there are a number of plausible, and largely benign, explanations for why China’s interbank rates spiked two weeks ago.

The following is an extract from a Capital Economics report.

The Fed is not in any immediate hurry to begin reducing the size of its monthly asset purchases, but it has begun to lay the groundwork for that change. Chairman Ben Bernanke was pretty explicit in his press conference, noting that if economic conditions improve as expected, it would be appropriate to start reducing the Fed’s monthly purchases “later this year” (probably September) and halt them completely by mid-2014, when the unemployment rate is expected to be down to 7.0%. In addition, the Fed’s new forecasts also suggest that the first rate hike could come earlier in 2015 than previously thought.

The key change in the new statement is that the FOMC now sees “the downside risks to the outlook for the economy and the labour market as having diminished since the fall.” Remember that when the Fed restarted its quantitative easing last fall, it pledged to continue with its asset purchases until the outlook for the labour market had improved “substantially”. The new language hints that the outlook has improved sufficiently to begin thinking about reducing the monthly purchases, even though the improvement hasn’t been substantial enough to warrant a complete halt.

Not all the voting FOMC members were convinced, however, with James Bullard apparently worried by recent low inflation readings. He wanted the statement to signal that the Fed was prepared to do more to make sure inflation hit the 2% target. He doesn’t appear to have convinced many of his colleagues, however, with the statement largely attributing the low level of inflation to “transitory influences”.

Turning to the Fed’s new economic forecasts, officials expect a more marked decline in the unemployment rate, which is now expected to end 2014 at between 6.5% and 6.8% and to finish 2015 at between 5.8% and 6.2%. That suggests Fed officials are, on average, expecting the unemployment rate to reach the 6.5% threshold, which could prompt a hike in rates, sometime in early 2015. (14 of 19 Fed participants expect the first rate hike in 2015.) (See Chart 1.) The Fed’s previous forecasts suggested that the unemployment rate wouldn’t get down to 6.5% until sometime in the second half of 2015. The prospect of an earlier than previously expected rise in short rates undoubtedly contributed to the post-announcement rise in Treasury yields.

Bernanke was at pains to point out that the timetable for all these policy changes is completely data dependent. If the unemployment rate falls towards 7.0% more rapidly than the Fed expects, then presumably it will be more aggressive in reducing its monthly asset purchases from the current $85bn per month. But it isn’t just about the level of the unemployment rate. A resurgence of financial market tensions or a further decline in inflation might persuade the Fed to hold off on its tapering. Similarly, if inflation was still below the Fed’s 2% target when the unemployment rate fell to 6.5%, it wouldn’t necessarily raise its policy rate from near-zero.

Finally, the Fed will only consider selling off its holdings of Treasury securities well after it has started to raise short rates, while it is now likely to retain its holdings of MBS until they mature – Surge in Japan’s exports not quite as good as it looks.

-   Euro-zone composite PMI may have risen to its highest level since January (10.00 BST)

-   China’s “flash” manufacturing PMI may have also edged up (02.45 BST)

Key Market Themes

There are a number of plausible, and largely benign, explanations for why China’s interbank rates spiked two weeks ago. The key question now though is why the People’s Bank (PBC) has allowed market interest rates to remain high since then. After all, cash crunches are not unusual in China, but they are usually reversed rapidly through liquidity injections by the PBC. This tolerance for tighter market conditions is particularly striking given current economic weakness.

In our view, the PBC is worried by the unsustainable growth rate of credit and is sending a message that market participants should not take for granted that they will always have access to cheap interbank loans. Reports in Chinese newspapers on Wednesday suggest that the big four banks lent more in the first nine days in June than in all of May. These bank lending figures are unofficial and we don’t have any such timely data on other credit. But total outstanding credit increased 22% y/y in May and is on course to hit 200% of GDP at the end of Q2, up from 130% in 2008.

Having shaken market participants’ complacency, the PBC may now be content to guide interbank rates lower. But looking ahead, it has a difficult balance to strike. The PBC’s credit concerns are well-placed. However, its efforts to dispel complacency in the financial sector could spill over into a decline in confidence.

At the very least, we would expect this episode to slow credit growth in the months ahead. The risks of a further slowdown in economic growth have increased. (For more, see our China Economics Update published on Wednesday.) (Mark Williams)

What to watch for today: North America

Markets were awaiting the publication of the FOMC statement at the time this edition of the Capital Daily was published. We do not expect the Committee to have announced any reduction in the pace of the Fed’s asset purchases.

At just under 5m annualised, existing home sales (15.00 BST) are still roughly 2 million lower than their average level during 2005. That would seem to suggest there is ample scope for further gains. However, with the wider economic recovery still best described as steady rather than spectacular, and 30-year fixed mortgage interest rates now more than 50bp above their low at the beginning of May, that seems unlikely in the near term. Both we and the consensus envisage that existing home sales will be 5m annualised in May. That would represent a 0.6% m/m rise, in line with the average gain over the previous six months. (Ed Stansfield)

We have pencilled in a rebound in the Philly Fed index (also 15.00 BST) to -2.0 in June, from -5.2 in May. Admittedly, the national ISM manufacturing index fell below the supposed boom-bust level of 50 in May. But the Fed’s latest Beige Book suggests that activity is expanding at a “modest to moderate” pace. Moreover, the headline index of the Empire State survey rose in June, although most of the sub-components fell. (Amna Asaf)

Continental Europe

We expect June’s euro-zone composite PMI (10.00 BST) to have edged up from 47.7 to 48.0, the highest level since January. In May, the new orders component picked up somewhat, boding well for this month’s reading. What’s more, sentiment and other data have improved a little over recent months, supporting the manufacturing PMI. This may also buoy the services index, but any rise is likely to be constrained by rising unemployment. However, at this level the index would still be consistent with quarterly falls in GDP similar to Q1’s 0.2%.

Elsewhere, we expect the Swiss National Bank (SNB) to leave monetary policy on hold at today’s meeting (08.30 BST). A further reduction in interest rates would risk further stoking the property market and lowering the franc ceiling would mean the Bank taking more currency risk on to its balance sheet and possibly attracting international criticism for fuelling a currency war. But if the Swiss economy slows later this year as we suspect that it will, negative interest rates might yet be employed.

Meanwhile, the Norges Bank is also likely to hold its policy rate steady today (09.00 BST), at 1.5%. Although the economy is growing strongly and household debt levels continue to rise, concerns about krona strength, even after the currency’s recent weakening, should prevent the Bank from hiking rates. (James Howat & Jennifer McKeown)

UK

The focus of George Osborne’s Mansion House dinner on Wednesday night is likely to have been the banking sector, with some possible hints at when he plans to return Lloyds to the private sector. Although we’d normally be looking at Mervyn King’s speech for some hints on where monetary policy might go, the Governor now only has two weeks left at the Bank. In any case, June’s MPC minutes (published on Wednesday morning) confirmed that the outgoing Governor Mervyn King was outvoted at his final meeting, with the vote to leave the quantitative easing programme at £375bn 6-3 for the fifth month in a row.

The official retail sales data for May (09.30 BST) are likely to show a small rise in spending on the high street. We are pencilling in only a modest 0.5% monthly rise in retail sales, which would leave sales roughly unchanged on an annual basis. (Vicky Redwood)

Japan

No major data or events scheduled for today.

The 10.1% y/y rise in the value of exports in May was comfortably above expectations. (Data reported on Wednesday.) But this impressive-looking headline largely reflects the mechanical impact of the fall in the yen on export revenues when translated into local currency. In contrast, the volume of exports actually fell month-on-month and is still lower than a year ago. There could still be an indirect impact on real GDP, depending on what companies decide to do with any increase in revenues. The best hope is that Japanese exporters will decide to increase summer bonuses (typically paid in June and July), thus supporting consumer spending. Indeed, there is already some anecdotal evidence that this is happening.

However, it seems unlikely that firms will significantly increase investment. For a start, the scope for lifting export volumes is limited by the weakness of global demand. What’s more, firms have plenty of spare capacity to increase output without adding plant or machinery. Finally, the downside of yen weakness is the impact on the import bill. Imports rose by almost as much (10.0% y/y) in May as exports, and because imports now exceed exports, the trade deficit actually widened. For many firms, then, higher revenues could simply be offset by higher costs. Overall, the double-digit rise in export revenues is clearly welcome, but the import bill is also surging and export volumes remain subdued. (Julian Jessop)

China

Today sees the release of flash estimate of the manufacturing PMI (02:45 BST) for June from HSBC and Markit. The latest data, including industrial production and retail sales, have provided little evidence of a meaningful rebound in the economy. That said, the recent pick-up in sales of construction equipment, a better gauge of investment activity than official investment spending data, may be an early hint that fast credit expansion since late 2012 is finally passing through into the real economy. Accordingly, we expect the headline PMI to pick up slightly this month. (Qinwei Wang)

Other Asia-Pacific

We think GDP growth in New Zealand (23.45 BST, Wednesday) slowed to around 0.7% q/q in Q1 from 1.5% in Q4. Monthly data on construction and building approvals suggest that investment has remained a strong driver of growth. However, government belt-tightening will be a persistent constraint on growth. The export outlook also remains subdued, and exports should be particularly weak in Q2 as a drought has hit agricultural output. Overall, we expect growth to average 2.5% for the full year. (Daniel Martin)

Other Emerging Markets

The monthly activity data point to a broad-based slowdown in GDP in Colombia in Q1 (17.00 BST). We are forecasting growth of just 2.0% y/y, down from 3.1% y/y in Q4 2012. On a seasonally-adjusted basis we estimate that the economy shrank by 0.5% q/q in Q1, following an expansion of 1.8% q/q in Q4. (David Rees)