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Wednesday June 11, 2008 - 14:28:19 GMT
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Forex Blog - Charge of Inflation-Light Brigade

Charge of Inflation-Light Brigade

Something major is underway in the halls of international monetary policy.  From Washington, to Frankfurt, to Ottawa and to London, central bankers are circling the policy wagons around inflation at a time when strong sustainable growth is far from assured.  King led the way putting policy easing on hold at 5% over a month ago as inflation nipped at the heels behind soaring commodity prices.  Bernanke fired his first major salvo at inflation (no disrespect to FOMC hawks like Fisher who were vociferous critics of easy monetary policy in the face of rising inflation) last Tuesday.  Trichet fired his on Thursday.  Then Geithner and Bernanke fired again Monday.  And Carney fired his salvo today, wrong-footing a market convinced the Bank of Canada will cut rates.     

Where did all this come from?  Well before I launch my conspiracy theory, if I had to bet on it central banks and later finance ministers in G7 came to the same conclusion independently before agreeing in the last 10 days that it makes sense to work together as one inflation rather than individually. 

But again why now?  Well central bankers face runaway commodity prices and rightly or wrongly this is linked to the weak dollar – commodities have a built-in hedge against a weaker dollar.  And central bankers are confident that the financial system may be hobbled by the credit crisis but is out of intensive care and with bed rest will emerge intact.  So with the credit crisis cauterized, central banks now can focus on inflation.

However, is it really inflation or something else?  It is really oil (and food) and yes second round inflation risks from rising oil (and food) price. 

We sense c bankers sense the credit crisis is contained, but we don’t sense the growth risk (to the downside is contained).  Hence premature rate increase to address inflation from rising commodity prices may not be the best course of action – did anyone else notice how Trichet Monday tried to inject more uncertainty than what was in the market after last Thursday’s press conference over the chance for a July rate increase by the ECB?

My point is central bankers, with the full backing of G7 finance ministers (Spain not included) are on board with talking tough on inflation while keeping powder dry on interest rate hikes.  And getting the dollar up by threatening rate increases (which may or may not be delivered) is a first round attempt to check rising oil prices (and inflation expectations generally).  Explosion in money supply in the wake of liquefying the banking system is also posing a problem for central bankers and talking market rates higher will do for monetary inflation impulses what can’t yet be addressed by official rate policy changes. 

A higher dollar (this is all about euro/dollar which correlates tightly with oil and gold and not about the dollar more broadly which remains overvalued versus Asian currencies including the yen) is the lowest common denominator for US and G7 authorities to get commodity prices down.  In time if growth returns to trend then rates will get jacked up rapidly to finish the job on inflation and inflation expectations (latter are up moderately but not exploding). 

Like any policy effort there are wrinkles in this approach.  As last Thursday proved getting central bankers and finance ministers to dance the tango is no easy feat (feet).  But there are other more significant risks such as a policy blunder.  Fed officials have succeeded in sending global rates up more than at anytime in over a decade in the last day.  If market rates rise on their “own” and by a lot and stick given market propensity to overshoot, it matters little if central banks actually hike.  Indeed central banks may be more able to manage market expectations with rate changes than simply threatening them with an indeterminate time frame and scope.  If and when the Fed for instance gets around to tightening it won’t be one and done or one and lengthy pause.  So putting the bug in the ear of the market about inflation worries and the need to hike with growth far from secure is an invitation to run across the deck of the interest rate ship.  If oil stays up and knocks households and firms off respective pedestals there will be little discussion about a policy response for inflation in say six months.

So open mouth policy is very hard to manage and this is especially so in the current environment of mini-stagflation – remember on Friday the jump in US unemployment rate in May set recession worries back into motion nearly instantaneously.

And managing the dollar via verbal intervention (and actual intervention – a growing risk) is anything but certain without fundamentals moving in the direction of the desired FX outcome…again in this case a higher dollar versus the euro to check commodity inflation.  But now that it is clear that the Fed is happy to appear locked and loaded on inflation and interest rates, the ECB is not nearly as out on a limb on inflation and rates as most thought last Thursday.  At least jawboning the dollar now does not risk being undermined by Trichet and the ECB, though it is only 3 weeks to the next Governing Council meeting and this condition could disappear instantly if the ECB hikes July03. 

Moreover jawboning without any policy shift – actual intervention (no panacea but a statement about disequilibrium and injection of greater 2-way risk) and rate hikes down the road – will leave the dollar short on fuel for a sustained rally.  Make no mistake about it the White House wants a stronger dollar (against the euro, C$ and stg) not simply a stable dollar.  And the Fed too wants a stronger dollar.  Ecofin/Eurogroup and ECB want this.  BoE and UK Treasury want this.  The Bank of Canada and finance ministry want this.  And for what it is worth the SNB and finance ministry want this. 

A higher dollar will create room for central banks to keep rates on hold and at the same time drive commodity prices down.  But markets will demand more than a change in the lyrics of FX madrigals sung by G7.  Markets have a way of demanding “show me the beef.”  I think currency intervention is likely ahead – rate hikes will be saved for a rainy day if verbal and actual intervention fails.  Oh, and if growth is not obliterated first by higher market rates and failure to get commodity prices down (dollar higher).

David Gilmore  



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