Friday October 6, 2006 - 15:26:24 GMT
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FX Briefing 6 October 2006 - Faites vos jeuxHighlights
â€˘ Dollar stands its ground despite reduction of interest rate advantage
â€˘ ECB switches to â€śmonitoringâ€ť after interest rate hike
Faites vos jeux
The forex markets are on stand-by: for weeks EUR-USD has been hovering around 1.27. The US dollar is remarkably firm given that in the past three weeks the markets have priced in a fed funds rate cut by mid-2007 and that the yield advantage of the USA over the euro area has shrunk by at least 10 basis points across the entire curve. The same applies to the dollar-yen exchange rate: USD-JPY is trading at around 118 at the end of the week, close to the six-month high it hit at the beginning of the week.
The ECB interest rate hike from 3.0% to 3.25% had been fully expected so it did not move the markets. And the press conference offered no surprises either â€“ at least at first glance. Mr Trichet said that, given the low interest rate level and ample liquidity, a further tightening of monetary policy was justified if the ECBâ€™s growth scenario was confirmed. He moreover pointed out that the economic recovery will be actually stronger than assumed and that prospects for the coming quarters will be better too if oil prices stay where they are. The ECB still sees upward inflation risks, mainly because of the possible ripple effects of the past energy price increases, administrative price hikes and stronger wage increases.
On the surface, Mr Trichetâ€™s comments confirmed the view that the ECB will unwaveringly follow its tightening course. But this is not written in stone. First, with a view to the interest rate hike in December that the markets are expecting Mr Trichet only declared that he did not want to say anything to correct this expectation. This is probably the weakest form of confirmation that a central bank is capable of. In addition Mr Trichet explicitly refused to comment at all on possible interest rate steps in 2007. And it might be significant that he no longer spoke of â€śprogressive withdrawal of monetary policy accommodationâ€ť but only of â€świthdrawalâ€ť.
Second, the ECB pointed out a number of inflation risks. But these risks are not acute: there is still no concrete evidence of price pressure. The core inflation rate in the euro area has been around 1.5% since the beginning of 2005. The VAT increase in Germany next year will push up the core rate, but even so euro area inflation is likely to be lower in 2007 than it was in 2006. We are forecasting 2.0% after 2.2%. The ECB too is apparently moving away from its unfavourable inflation projections from the end of August (2.4% for 2006 and 2007). Mr Trichet just spoke of an average inflation rate of over 2% in 2006 and probably over 2% in 2007.
Yesterday the ECB reduced its state of alert from â€śstrong vigilanceâ€ť to â€śmonitoring very closelyâ€ť. It is thus following the same pattern it applied at the beginning of August when the refi rate was raised to 3%. If the ECB continues to do so, it would have to go back to â€śstrong vigilanceâ€ť at the beginning of November. But by then we will have seen another month of very low inflation â€“ maybe as low as 1.7%. Moreover the central bank will have a first idea of its new projections which will be published in December. It will be interesting to see how the ECB manages to reconcile its intention to raise interest rates with the foreseeable downward revision of its inflation forecasts for 2006/07 â€“ especially since the higher growth momentum in Q3 and Q4 2006 might be distorted upwards because of purchases being brought forward to avoid the VAT hike in Germany and since therefore we might see a corresponding dip at the beginning of 2007. We think that slowing the pace of its interest rate steps would be an adequate and elegant solution.
If the ECB does reduce the pace of its tightening, the dollarâ€™s currently latent strength might turn into a significant upward movement: Faites vos jeux.
Stephan Rieke +49 69 718-4114
+49 69 718-3642
Foreign Exchange Trading
+49 69 718-2695
Matthias Grabbe / Klaus NĂ¤fken
+49 69 718-2688
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