Wednesday June 11, 2008 - 14:28:19 GMT
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Forex Blog - Charge of Inflation-Light Brigade
Charge of Inflation-Light
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
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 â€“ 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 donâ€™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 â€“ did anyone else
notice how Trichet Monday tried to inject more uncertainty than what was in the
market after last Thursdayâ€™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 canâ€™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 â€śownâ€ť 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 wonâ€™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 â€“ 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 â€“ a growing risk) is anything but
certain without fundamentals moving in the direction of the desired FX
outcomeâ€¦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 â€“ actual intervention (no panacea but a statement about
disequilibrium and injection of greater 2-way risk) and rate hikes down the
road â€“ 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 â€śshow
me the beef.â€ť I think currency intervention is likely ahead â€“ 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).
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