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Saturday October 15, 2005 - 11:27:54 GMT
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FX Briefing 14 October 2005

• US central bank emphasizes growing inflation concerns in speeches and minutes
• US data and Beige Book will probably confirm Fed’s position
• G20 summit of finance ministers and central bankers in Beijing unlikely to affect dollar

Dollar firmly in Fed’s interest rate grip

The dollar has remained stable. After a brief trip in the direction of 1.22 towards the end of last week, EUR-USD fell again during the course of the week to 1.1914. However, whereas the euro is still a long way from its former lows (1.1868 in July 2005, 1.1761 in April 2004), USD-JPY reached a new 17-month high at JPY115.10. But then the dollar bulls lost courage and the USDJPY rate fell to below JPY115, while EUR-USD strengthened to about USD1.20 – albeit before the release of US inflation data.

US interest rate policy remains the predominant theme on the forex markets. The minutes of the FOMC meeting of 20 September, published a few days ago, and numerous other statements by Fed representatives make it quite clear that the US central bank is not planning to end its policy of interest rate hikes in the near future. The central bankers have been incessantly stressing their determination to fight the inflation dragon. Above all, the news that US import prices had risen in September by 2.3% mom, (9.9% yoy), gave the dollar an extra push. The dollar’s sensitivity to unpleasant surprises on the price front is particularly high because of the imminent release of the September consumer prices.

Meanwhile the markets are seeing the interest rate sword being well sharpened. According to futures contracts, the fed funds rate will be around 4.50% in spring 2006 with potential for a further interest rate step. That is even more than was expected in August, before Katrina. It seems to be increasingly clear to market players that, due to the economy working almost to full capacity and then Katrina, inflation risks have become the main concern for the central bank. Through the hurricanes, the US economy is being confronted simultaneously with a negative supply shock (as a result of the energy supply shortage) and a positive demand shock (due to privately and publicly financed reconstruction). Both impulses tend to cancel each other out from a growth point of view, but reinforce each other from a price effect perspective. Taking into consideration the fact that the core inflation rate had been approaching the limit of what stability policy can condone, the central bank is forced to ask itself whether the interest rate level should not even be raised above the neutral level.

At the moment the main thing that speaks against acting much more aggressively is that the impulses are only temporary. The majority of the expected additional private and public expenditure will be concentrated in the current and the coming year. With the restart of energy production on the Gulf coast, the supply situation will probably ease up somewhat, which is indicated in the recent drop in energy prices. However, the global shortage situation, which led to massive price increases in the course of the summer up to the present day, will remain unchanged. A colder than usual winter in the northern hemisphere, which some meteorologists are forecasting, could quickly make things a lot worse.

The basically temporary impulses will become a problem for monetary policy if price increases start snowballing, that is, if there are second and third round effects which increase companies’ and private households’ inflation expectations. Predominantly with a view to containing inflationary expectations, the rattling of the dragon slayers’ swords ( N.B. – on both sides of the Atlantic!) can be seen as justified.

The game theory of Robert Aumann and Thomas Schelling, this year’s winners of the Nobel Price in economics, throws an interesting light on this. One thing they found out was that the selfcommitment of one player increases the deterrence effect because the other player can better assess the consequences of his decisions. By making clear publicly and in advance that ensuring price stability is its main aim, the central bank signals to companies and households that price and wage increases will not be accommodated by monetary policy. Such a threat encourages cooperative behaviour and leads to better results for all participants – without the threat having to be carried out in the end.

We expect next week’s data and publications to confirm the markets’ interest rate hike expectations. The first business climate indicators for October, the New York Empire Manufacturing index and the Philly Fed index are likely to bounce back after the setback in September. The Beige Book will probably once again describe the economic development as stable overall, notwithstanding the weakness in the regions and industries affected by the hurricanes. Here too the crucial factor is the development of prices, especially to what extent energy price rises are being passed on. Apart from that, attention will probably focus on the international securities transactions between the US and the rest of the world. Anecdotal and statistical evidence from Japan, in particular, indicates that interest in US bonds is on the rise.

The latest signals from China, where the G20 finance ministers and central bank governors will meet tomorrow, have been harmonious. US Treasury Secretary John Snow had called for more movement in the USD-CNY exchange rate system, in a politely veiled threat mentioning the upcoming November report of the Treasury on exchange rate manipulations and the Schumer- Graham Bill on penalty tariffs, which has been shelved for now. Currently China is back to assuring that it is basically prepared to be more flexible but that it needs time to adjust to more market-oriented structures. John Snow, too, has become more conciliatory. He said that it was in China’s interest to continue moving towards more flexibility in its exchange rate regime but that the US had no fixed schedule for the adjustment process. So we do not expect anything to weigh on the dollar from this side either.

Stephan Rieke +49 69 718-4114
Economics Department
+49 69 718-3642
[email protected]
Foreign Exchange Trading
[email protected]
Jörg Isselmann
+49 69 718-2695
Matthias Grabbe / Klaus Näfken
+49 69 718-2688

This report has been prepared by BHF-BANK Aktiengesellschaft on behalf of itself and its affiliated companies (together "BHF-BANK Group") solely for the information of its clients. The information and opinions in this document are based on sources believed to be reliable and acting in good faith, but no representation or warranty, express or implied, is made by any member of the BHF-BANK Group as to their accuracy, completeness or correctness. Opinions and recommendations are given in good faith but without legal responsibility and are subject to change without notice. The information does not constitute advice or personal recommendation, for which the duty of suitability would be owed, but may facilitate your own investment decision. Moreover, you should seek your own advice as to the suitability of an investment matter mentioned herein. Investors are reminded that the price of securities and the income from them can go down as well as up and that the past performance of an investment or a market is not necessarily indicative for future results. This document is for information purposes only. Descriptions of any company or companies or their securities mentioned herein are not intended to be complete, and this document is not, and should not be construed as, an offer to sell or solicitation of any offer to buy the securities mentioned in it. BHF-BANK Group and its officers and employees may have a long or short position or engage in transactions in any of the securities mentioned in this document, or in any related securities. This publication must not be distributed in the United States.
© 2005 BHF-BANK Aktiengesellschaft
All rights reserved. Please mention source when quoting from it.


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