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Tuesday August 10, 2004 - 20:20:49 GMT -

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DailyFX Research: Fed At The Mercy Of Oil

DailyFX Forex Fundamentals 08-10-04

By Kathy Lien, Chief Strategist

· Fed Raises Rates By 25bp to 1.50% - Hawkish Comments
· Oil Jitters Continue To Rattle Markets
· Softer UK Inflation and Wider Trade Balance


In a nutshell, the Federal Reserve raised interest rates by 25bp to 1.50%, kept the word “measured” in their statement, acknowledged the slowdown in the labor market and moderation in output growth, but injected a bit of optimism by saying that “the economy nevertheless, appears poised to resume a stronger pace of expansion going forward.” There is age-old rumor that Alan Greenspan pens the FOMC statement prior to the monetary policy meeting and in light of today’s events, if that is the case, then the more bullish comments still appear to be a “face saving” measure. The statement’s focus on energy prices as the main culprit for the recent softness suggests that the Fed is hanging on the single hope that oil prices will moderate, which is a risky bet. In June, the Fed began its campaign that the rise in inflation is based upon “transitory factors” but since June 30th, oil prices have been on a one-way uptrend, rising close to 25%. However, in Greenspan’s defense, monetary policy has been very accommodative for some time now. This means that the additional rate hike will do more in terms of relaxing excessive accommodation and helping to curb inflation rather than sticking a wedge into growth. Based upon today’s price action in the euro, the markets once again have fallen back on its tendency to put their faith in their almighty Chairman.


The Fed’s 25bp interest rate hike and bullish outlook for stronger growth going forward has helped the dollar recoup some of its non-farm payrolls induced losses. Elaborating further on FOMC, the Fed is using the statement to tell us that they are keeping a close eye on economic releases, which is what we should be doing going forward as well. It should come as no surprise that what we need to watch is retail sales (due out on Thursday), the trend of PPI and CPI (due out at the end of this week and next) and most importantly, oil prices. We cannot stress enough that it all boils down to oil. The pre FOMC spike in the euro was induced by news that storms threatened oil outputs in the Gulf of Mexico. This caused oil prices to rally above $45/barrel. However, the rally was quickly reversed on news that Iraq will be resuming oil exports from their southern oil fields, after temporarily halting them on threats from terrorists. As you can see, oil moves markets and today’s FOMC statement suggests that not only does it move markets, but it also dictates monetary policy.


As we mentioned yesterday, we believe that mixed data is a predecessor to slower growth. Yesterday, we saw higher PPI output prices and stronger house price inflation. In contrast, today we have softer inflation reports and a wider trade balance. Consumer prices fell by the largest amount in 6 months as a result of increased discounts on consumer products. This fits neatly into the Bank of England’s forecast for a dip in inflation prior to a resumption of “rising inflation pressures” by the end of the year. The trade balance also widened from a revised –GBP4.825Bln to –GBP4.973bln. The market had expected the deficit to shrink, but instead, lower oil exports has caused a widening of the deficit. The key release will be tomorrow’s Bank of England Inflation report. It will be interesting to see whether the BoE addresses the recent trend in inflation and its impact on the need for additional interest rate hikes.


As expected, the Bank of Japan kept monetary policy unchanged last night. The central bank has previously informed the markets that they will not be raising rates until consumer price inflation has increased for a few months. Although the BoJ kept their optimistic assessment of the economy unchanged in their August monthly report, they did warn about the negative effects of the record-breaking rally in oil prices. In last month’s report, the BoJ had said that ''Japan's economy is expected to continue to recover, gathering stronger momentum.'' Meanwhile, a strong economy has helped drive consumer confidence to a 13-year high as consumers are have become more optimistic about employment, income growth, living standards and purchases of durable goods.


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