 Nominal spending over the past 3 months through April remained strong, up nearly 7%

annualized. However, real spending growth slowed substantially from 4% to about 2%. The
widening difference between the two largely represents the incremental nominal spending that was
required to pay for higher-priced gasoline and energy products.

 Energy prices at the consumer level are ultimately driven by changes in oil prices, with a lag. The
recent drop in oil prices has not yet passed through to consumers; this will allow price pressures to
fade in coming months, as long as oil prices do not resume their rise. This presents an interesting
question as to how much of a pickup in growth the stabilization in oil prices (along with equities
still near their highs and interest rates falling) may foster.

 With respect to income, it is important to keep in mind the extent to which the government is
supporting the current level of income. Disposable income is only about 1% of potential GDP less
than it was before the crisis, but the decline would have been closer to 7% were it not for fiscal
supports (both normal cyclical stabilizers and stimulus). Some cuts in government support are
already in the pipeline and will be a drag on income growth and spending. The more aggressive
fiscal austerity plans now being considered would substantially increase this drag. The following
chart shows the level of privately sourced income (red) and the aggregate level of disposable
income of households. The difference represents the support of government.
 Private sources of income (shown above in red) have been growing at a healthy rate of 4%-5%

 Real spending growth has fallen faster than nominal spending growth due to the impact of higher
prices. Real spending has weakened globally and has spread to the business sector. If the
weakness in spending spreads to employment, it would bring down income growth and could
trigger a deeper self-reinforcing process. On the other hand, to date, nominal income growth and
nominal spending remain fairly strong and a stabilization of food and energy prices will relieve
some of the related downward pressure on growth. We expect the ongoing global tightening of
monetary and fiscal policies to favor additional weakening, with oscillations around the slowing
trend caused by various forces, including the swings in food and energy prices.

 Japanese statistics for April point in aggregate to a very muted rebound in April from the large
decline following the earthquake. The magnitude of the initial shock was greater than other
natural disasters in the last 30 years and so has been the original decline in economic activity (with
production falling 15% in March). The weakness in recovery is particularly true on the production
side, where after a decline that was worse than that experienced by any major economy in at least
50 years, there was a meager improvement of about 1%. It is important to note that for the next
several months, it will be difficult to reach a precise read on the trajectory of the economy because
the statistics are likely to be extremely volatile as Japan begins to recover from such depressed
levels.
 The following chart shows the average path of industrial production through major disasters. The
typical pattern is that production falls sharply at first (approximately 5%) and then recovers most
of that decline over the next several months. Given Japan’s 15% decline in production, a slower
rebound to some extent is not really surprising, given the evident magnitude of the crisis and the
added nuclear and power dimensions.
  However, prior to the earthquake much of Japan’s industry was struggling with
competitiveness. In Japan’s case one important question is to what extent some of the
production will never return following the disruption to global supply chains, as it’s possible
that the earthquake may have accelerated a shift away from Japanese manufacturing that in
some cases could become permanent.
 A reasonable baseline of the potential magnitude of constraint on growth globally caused by
the Japanese earthquake can be had by looking at the direct impact on the global economy
from a reduction in Japanese imports caused by the roughly 10% shock to demand that
occurred in the aftermath of the earthquake. While that impact will not persist as Japan
recovers, it is likely to create a modest reduction in global growth of roughly -0.30%. That
rough number is only a baseline and does not include those potentially material indirect
impacts.

 The level of industrial production even prior to the crisis had already been relatively depressed and
was coming into March about 12% below pre-crisis peak – Japan’s recovery in production has
been among the weakest in the world in terms of production levels relative to pre-crisis peak
levels. It is now 24% below its pre-crisis level.
 The table below summarizes the April Japanese statistical releases and provides a short
interpretation of the statistics:

 Employment conditions continued to deteriorate for a second month, and while job losses in April
were not as extreme as those in March, the weakness was somewhat more broad-based with
moves down in employment, job availability, and a tick up in the unemployment rate. Of course,
the key thing to remember is that these unemployment numbers continue to be compiled excluding
any records from the three prefectures hardest hit by the earthquake (Iwate, Miyagi, and
Fukushima), so unemployment conditions in aggregate are undoubtedly much worse. If the
weakness in production continues, it could be a considerable drag on employment for some time.
 Prices continued to show little sign of an obvious shock from the crisis at least for now. Deflation
in Japan has been entrenched for some time but had shown signs of moderating before the crisis.
That trend appears to be intact.

 May nearly rivals the worst single months of the financial crisis in terms of magnitude of negative
surprises relative to consensus expectations of economic releases.
 As it stands now, growth is still above potential in most of the emerging world, and a support to
developed world growth. In terms of implications for emerging economies, we expect that a
combination of above-average growth, limited economic slack, and rising inflation will ultimately
require more tightening and will result in more currency appreciation than is currently discounted.

 Capacity in the emerging world is already tight, with most countries operating at output levels
significantly above potential. This implies increased pressure to raise wages and prices.

 Income growth has been supported through both rapid job creation and rising wages. Employment
growth is extremely strong relative to history.
 These wage increases have also been outpacing headline inflation measures, creating more real
purchasing power. If nominal income gains continue, they should lead to more spending and
demand growth.

 The table below gives a better picture of how this has played out across countries. Those
countries with cyclically tight conditions (China, India, Brazil, Indonesia, Singapore) have
generally seen the highest wage growth.
 Despite these recent wage gains, however, the overall emerging market export share of the world’s
non-commodity imports has continued to rise at about the same pace as it has throughout the
decade.

 The other major boost to spending power in any country is the desire to borrow and credit
availability. China has been the biggest global credit creator since the crisis, with massive
amounts of credit creation being shelled out through the banking system and growing non-official
financing channels. So far, the biggest contributor to global tightening has been the attempts
Chinese authorities have made to rein in credit lending over the past few months, trying to prevent
asset bubbles and inflation pressures from worsening. We have probably already seen some of the
effects of slowing credit creation in the form of weakened Chinese import and demand data,
though there will likely need to be more tightening given the still rapid pace of credit creation
even at these lower levels.

 In the rest of the emerging world, credit conditions remain very favorable, with strong business
and household income growth and generally healthy banks. These conditions have translated to
strong credit growth in every region of the emerging world, although strongest in Asia.
 We are early into the tightening cycle in the emerging world, and despite the recent slowdown in
demand figures, the strength in overall growth and the continued inflationary pressures warrant
higher interest rates. The chart below shows that the current tightening cycle is barely visible
compared with past emerging market cycles. It is possible that all of the quantitative measures
taking place in order to avoid interest rate hikes will work at preventing overheating, but is
seemingly unlikely.

 Markets are also pricing in the same amount of tightening in the emerging world as in the
developed world, which seems to underestimate the difference in relative growth and inflation
pressures in the region. Relative tightening between the regions needs to continue, and some
combination of further currency appreciation and/or interest rate increases will be necessary to do
so.