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Friday May 19, 2006 - 15:04:48 GMT
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FX Briefing 19 May 2006

• Further sharp rise in US core inflation in April
• Fed funds rate rise in June much more likely

USA: Caught between growth concerns and inflation risks

For the first time in five weeks, it looks as though EUR-USD is ending the week without making any gains. At the beginning of the week, the European currency reached the highest level so far this year at 1.2972, but then dropped again. After the release of US consumer prices, the euro traded at around 1.27 for a short time, but then recovered a little. Whereas EUR-USD began to weaken at the start of the week, the yen strengthened further initially. By Thursday, USD-JPY slipped to 109, but rose again to around 112 after the CPI data was published.

The key event of the week was the release of US consumer price data. The relatively moderate development of core producer prices and weak housing market data on Tuesday put market participants in a bullish mood towards the euro again, also because the yen held its ground against the dollar. In this scenario, the news that consumer prices excluding food and energy had risen again in April by 0.3% month-on-month, dropped like a bombshell. The main reasons for the rise were higher rents (or more precisely, owners’ equivalent rent) and higher clothing prices. Compared with the previous year, the rate increased from 2.1 to 2.3%. Due to the sharp rise in energy prices, the overall inflation rate accelerated slightly again to 3.5%, despite a favourable basis effect.

Generally, errors of one or two tenths in consumer price index forecasts would not be enough to upset the markets. However, in the current environment, this could just tip the scales towards calling off the pause in the tightening cycle expected for the end of June: Core CPI had already risen by 0.3% in March, also because of higher housing costs. Thus the price increase over the last three months is 3.2% annualised – the highest rate since 1996. Even if prices increased at a more moderate pace in the next few months, core inflation would still accelerate during the course of the year: at 0.2% per month, the core rate would have risen to 2.6% by late summer.

A core inflation rate above 2.5% is presumably no longer within the Fed’s comfort zone. With this prospect in mind, the central bank will probably find it more difficult to describe inflation as “contained”. Moreover, the indicators for inflation expectations, which play an important role in the Fed’s assessment of inflation momentum, are no longer altogether favourable either.

So far, inflation expectations gauged for example by the University of Michigan consumer surveys, are showing a relatively moderate upward adjustment. During the hurricane season last year the expectations in the surveys had risen much more sharply. On the other hand, the implicit inflation expectations reflected in the inflation indexed Treasury Notes, accelerated quite significantly in April. For the next ten years, the implicit (average) inflation expectation is around 2.7%. These levels were also reached in May/June 2004 and in March/April 2005 and as such are nothing spectacular, but they are around the previous years’ upper limit.

Only a couple of weeks ago, the Fed had announced its intention to pause in its tightening process. Apparently the inflation risk was not rated much higher than the danger of a further interest rate hike slowing growth too much.

In fact, some real economic indicators are signaling that things are slowing down. Due to statistical effects alone, private consumption will probably increase far less in Q2 than in Q1. There was less momentum in April retail sales too. Consumer surveys are also indicating a less optimistic mood at the moment, partly because of the drastic increase in gasoline prices. The housing market is weaker, which is underlined by the latest housing starts data. Finally, the first available surveys in the manufacturing sector for May are also giving mixed signals.

From the markets’ point of view the central bank will thus be caught in a dilemma. Accelerating inflation might force the Fed to tighten interest rates further although the economy is displaying the first signs of weakness. For to maintain its credibility, the central bank would presumably be prepared to accept a further loss of growth momentum. Fear of a monetary policy overkill is the main reason behind the sharp drop in equity markets and, later, the strengthening of bond markets at the long end. The forex market is apparently unsure what to make of the increased probability of a fed funds rate hike at the end of June and possibly at subsequent meetings.

The first reflex would be to go into the dollar because of higher interest rates in the US. At least this pattern has explained market behaviour in the past quite well. On the other hand, higher central bank rates leave an unpleasant aftertaste if combined with growth worries, falling equity markets, and a flatter – or possibly even inverted – yield curve. This is all the more so when it coincides with sustained strong political pressure to make emerging markets’ currencies more flexible because of the global current account imbalances.

But from our point of view it would be rash to bet on a downswing in the USA. In the past years the robustness of the US economy has generally been underestimated. The economic indicators are so far showing little more than the typical monthly or quarterly fluctuations of economic activity, not a downturn. And the equity market drop is a correction rather than a collapse. So the higher probability of US interest rate hikes might after all have the potential to back up the dollar, vat least for a while.

Stephan Rieke +49 69 718-4114
The next FX Briefing will be published on 2

Economics Department
+49 69 718-3642
[email protected]
Foreign Exchange Trading
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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.
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