Data over the past month has merely been a continuation of the trend that started in early spring: inflation indicators have strengthened while activityindicators have worsened. One brief ray of light was the much better-than-expected retail sales, sparked higher by exceptionally warm weather in May, which spurred sales of seasonal food and clothing. But on the whole, data was worrying, which was best confirmed by the large drop in the important PMI index, now contracting the most since 2001. In the short term, the BoE has its hands tied due to rising inflation. CPI inflation is set to rise further. In our forecast, inflation will move up towards 4.5% in October-November before falling back gradually. Inflation will probably be in 'letter-writing' territoryuntil late summer/early autumn 2009. This implies that the Governor of the BoE, Mervyn King, may have to write around six letters to the Chancellor (for every third month that inflation is above 3% (below 1%), a letter is required).
Niels-Henrik Bjørn Sørensen, Senior Analyst, Danske Bank
Weekly Bank Research Center 07-14-08
A Nuanced Inflation Shock to Emerging Economies
Stephen Roach, Head Economist, Morgan Stanley
Contrary to popular presumption, EM economies have a legitimate choice to either fight to stay ahead of the curve on inflation or accommodate the inflation shock and protect growth. How the investment community reacts to different policy choices will be a function, among others, of its opinion of what EM economies should do. Our guess is that, given that most macro investors appear to have the view that ‘inflation is bad’, the currencies of countries that try to fight inflation may initially be rewarded while those of countries that accommodate inflation may be punished. However, the reaction of the equity markets may be exactly the opposite, that dovish policies that protect growth could be received more favourably. This is an issue because EM, for the first time in over a decade, is facing an upward drift in inflation. While much of this has so far been fuelled by internationally determined food and energy inflation, these items make up such large portions of the CPI baskets in EM that they will most likely have spillover effects on other products and services. EM inflation (proxied by the BRICs) has been steady declining since the mid-1990s, and only the Asian Currency Crisis temporarily disturbed this otherwise steady trend. Recently, however, headline inflation has accelerated, with core inflation starting to be dragged modestly higher.
GBP Set to Weaken Further Over Summer
Niels-Henrik Bjørn Sørensen, Senior Analyst, Danske Bank
Data over the past month has merely been a continuation of the trend that started in early spring: inflation indicators have strengthened while activity indicators have worsened. One brief ray of light was the much better-than- expected retail sales, sparked higher by exceptionally warm weather in May, which spurred sales of seasonal food and clothing. But on the whole, data was worrying, which was best confirmed by the large drop in the important PMI index, now contracting the most since 2001. In the short term, the BoE has its hands tied due to rising inflation. CPI inflation is set to rise further. In our forecast, inflation will move up towards 4.5% in October-November before falling back gradually. Inflation will probably be in 'letter-writing' territory until late summer/early autumn 2009. This implies that the Governor of the BoE, Mervyn King, may have to write around six letters to the Chancellor (for every third month that inflation is above 3% (below 1%), a letter is required).
Housing, Energy and Credit Dictate No Fed Funds Rate Change
E. Silvia, Ph.D. Chief Economist, Wachovia
The three issues we have emphasized: housing, energy prices and credit continue to suggest no change in the federal funds rate at least through September. Therefore, the view expressed in the press that some analysts are split on the growth/inflation choice reflects a false dichotomy. The domestic private economy is in recession in part because rising prices of essential commodities such as energy and food have reduced the gains in real disposable income for consumers and lowered profits for non-financial companies. Moreover, deflation in asset prices for homes and equities that has lowered household wealth and delivered large profit losses for financial sectors. The U.S. economy is experiencing a significant shift in relative prices for financial and real assets relative to globally traded commodities and this naturally brings hardship in the transition. While below trend economic growth remains our expectation for the rest of this year, as it has been since January, some sectors such as agriculture, technology and exports are doing well. Once again there is no clear, across-the board theme in the economy. There are opportunities as well as pitfalls.
Under My Roof
Steve Chan, Economist, TD Bank Financial Group
As was evident in his testimony to the U.S. House Committee on Financial Services on Thursday, Fed Chairman Bernanke is eager to push through reforms and more than willing to bolster the responsibilities of the entity he happens to chair. Recent events stand behind him and provide a fair bit of momentum for a stronger and more proactive Fed going forward. Like any good parents, the Fed is willing to help its children along so long as they play by its rules while living under its roof. Investment banks seemed to be the new, neglected kid on the block, and the Fed has taken them in. In helping along what is akin to an adoption application, the Fed announced on Tuesday it would likely keep the primary dealer credit facility open into 2009 “should the current unusual and exigent circumstances continue to prevail”. You don’t threaten to show the door to the adopted kid when he’s just coming to his new home from rehab. The primary dealer credit facility, a makeshift guest room of sorts, was created in March to extend to investment banks loans previously only available to commercial banks. The markets rallied and let out a sigh of relief at the announcement. It’s not so much that the facility was being used much of late – after peak loan extensions of up to $38.1 billion in early April, investment banks have gradually cut back on use of this facility since then, down to only $1.7 billion last week. But it is soothing in an important way, especially in a week during which the solvency of mortgage corporations Fannie & Freddie were questioned. It’s like knowing that the local Dairy Queen drive-through window is still open in September, on the off-chance you get summer-like temperatures. As a result of the near-collapse of Bear Stearns in March and the Fed’s consequent intervention to secure a buyout from JPMorgan, investment banks know the price to pay for a comfortable place to sleep is that Dad (a.k.a. the Fed) will be looking over their shoulder. The birth parents (a.k.a. the SEC) will no doubt have extended visiting rights and will actively remain involved on the enforcement side. It would only make sense, after all, that a marriage of economists (Fed) and lawyers (SEC) produce better citizens than either could by themselves.
UK Inflation Data Key This Week
Trevor Williams, Chief Economist at Lloyds TSB Financial Markets
The UK, the US and the Eurozone (final) CPI inflation data are likely to highlight the monetary policy dilemma facing central banks. The Bank of England kept base rates steady at 5% at last week's MPC meeting, despite CPI inflation running well above the 2% target and projected at 3.6% in May, and there is clear evidence that Q2 growth slowed further from 0.3% in Q1, preventing a rate hike. This week's publication of a fifth consecutive rise in claimant count unemployment may exacerbate economic concerns. Since raising interest rates by 0.25% to 4.25% on 3 July, the ECB has adopted a neutral position on future interest rates, but there is still a possibility that it will do another 0.25% hike by the end of the year should CPI inflation surprise on the upside (expected to be confirmed at 4% in June) and/ or economic growth proves more resilient. The Fed publishes the minutes of its 24-25 June meeting, and Bernanke's semi-annual Monetary Policy testimony to the House Financial Services Committee will outline the Fed's latest projections for GDP growth, employment and CPI inflation in 2008-10. The Bank of Japan and the Bank of Canada are likely to hold interest rates at 0.5% and 3%, respectively.
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