Although it is a pretty safe bet that the FOMC will leave the federal funds rate unchanged at 2%, there is considerable uncertainty about what signals the press release will send out. A clear shift in the Fed's communication is likely, but how strong a shift depends entirely on how the balance between the doves and the hawks on the FOMC has changed since last time around.
Niels-Henrik Bjørn Sørensen, Senior Analyst, Danske Bank
Weekly Bank Research Center 06-23-08
Some EM Central Banks to Be Stress-Tested by Inflation
Stephen Roach, Head Economist, Morgan Stanley
Global energy and food price inflation poses a major challenge for monetary authorities around the world, with implications for currencies. Up to a certain threshold, say 6%, inflation should be positive for developed market currencies, in our view. Most central banks enjoy a meaningful enough amount of credibility that upside surprises to inflation should make investors look for eventual monetary tightening. The rule-of-thumb, thus, should be to buy the G10 currencies of countries that have upside surprises to inflation. Having said this, it is important to appreciate the acute dilemma monetary policymakers are facing, and that, at some stage, if these types of global inflation persist and accelerate, central banks in developed economies may have rather diverse reactions and approaches, and the aforementioned simple rule-of-thumb would no longer be appropriate.
Rate-Setting Meeting at the Federal Reserve
Niels-Henrik Bjørn Sørensen, Senior Analyst, Danske Bank
Although it is a pretty safe bet that the FOMC will leave the federal funds rate unchanged at 2%, there is considerable uncertainty about what signals the press release will send out. A clear shift in the Fed's communication is likely, but how strong a shift depends entirely on how the balance between the doves and the hawks on the FOMC has changed since last time around. There is undoubtedly broad disagreement between the different camps on the FOMC, and so the statement will always be something of a compromise. While the press release generally provides a pointer as to where interest rates are headed, the FOMC has chosen not to do so several times in the past when there has been great uncertainty, and this may very well be the case again this time around. If there is an explicit signal, we reckon that the FOMC will opt to be relatively cautious. The economy is still weak, and the financial markets fragile. The inflation outlook also depends heavily on oil prices, which can change very quickly. It therefore seems most likely that the rhetoric will not be tightened to any great degree. In other words, there will be no clear signal of higher interest rates around the corner.
BoE Governor Writes a Letter
E. Silvia, Ph.D. Chief Economist, Wachovia
Data released this week showed that CPI inflation in the United Kingdom rose to 3.3 percent in May. Not only was the outturn the highest year-over-year rate of inflation since the early 1990s, when sterling’s sharp depreciation in the wake of the currency crisis cause inflation to soar, but it also led Bank of England (BoE) Governor King to write an embarrassing letter. The Bank of England Act of 1998 gave the Monetary Policy Committee (MPC) an inflation target of 2 percent. If the target is missed by more than 1 percentage point, the Governor is required to write an open letter to the Chancellor of the Exchequer explaining why the target was missed and outlining the steps the MPC will take to ensure inflation returns to target. Within hours of the CPI inflation release, Governor King had published his letter to Chancellor Darling. The Governor explained the rise by “large and, until recently, unanticipated increases in the prices of food, fuel, gas and electricity.” Indeed, the core rate of CPI inflation, which excludes food and energy prices, is only 1.5 percent at present. Therefore, the Governor is arguing that factors beyond the control of the MPC have caused CPI inflation to breech the Bank’s target. That said, this is no time for complacency in the fight against inflation. Although wage growth has been stable, the Governor acknowledged that wages could shoot up if workers seek to offset reduced purchasing power caused by recent sharp increases in food and energy prices. Wage acceleration would surely lead to an increase in core inflation. With the potential for core inflation to move above 2 percent, the probability of a rate cut is very low.
Shoot First, Answer Questions Later
Steve Chan, Economist, TD Bank Financial Group
The European Central Bank (ECB) and U.S. Federal Reserve (Fed) had already upped the ante in a series of speeches and remarks which highlighted their concerns over inflation. So much so that they had to backtrack this week to help counter expectations that they were soon to embark on an aggressive hike cycle. While the ECB will almost surely raise its key interest rate by a quarter point to 4.25% in July, officials have been quoted saying that should be enough to bring inflation back below the 2% target within 18-24 months. Meanwhile, Fed officials tempered expectations of a near-term policy reversal, suggesting they are most likely leave the Fed Funds rate unchanged at 2.00% next week. Last week’s decision by the Bank of Canada (BoC) to hold the line on interest rates, rather than deliver a quarter point cut as markets expected in the face of a significant economic slowdown, was the first salvo in Canada aimed at anchoring down inflation expectations. But it came with no prior warning and the communiqué accompanying the decision provided little in the way of explaining the shift. However, Governor Carney provided detailed insights into the decision in a speech in Calgary on Thursday night. The rationale provided is that “commodity prices, as measured by the BCPI, rose 10 per cent over the period between decisions, and the futures curve for oil moved sharply higher. This will support domestic demand. Other considerations included stronger global growth than previously expected and higher global inflation, which increases the risk of higher-than-projected costs for Canadian imports. In addition, many of the downside risks to inflation have eased.” The BoC also clarified its current stance as neutral, stating that “going forward, there remain important downside and upside risks to inflation, but these risks are now judged to be evenly balanced”, which firms up our view that neither hikes nor cuts are likely this year.
Is the Credit Crisis Over? Falling Liquidity Risk Versus Rising Default Rates
Trevor Williams, Chief Economist at Lloyds TSB Financial Markets
Since the Fed’s rescue of Bear Stearns in March and the acceptance of wider collateral by the world’s central banks, including the Bank of England with its Special Liquidity Scheme, there have been signs that the worst of the credit crisis may be over. In the UK, interbank rates have fallen slightly in recent weeks, though they remain well above the Bank rate by historical standards. Global corporate credit spreads and credit default swaps have also fallen, reflecting lower liquidity risk premia, as financial market confidence slowly improves. Hence, credit spreads, especially in the synthetic markets, are now nearer our estimate of fair value. However, the recent falls in credit spreads have to be balanced with prospects of rising corporate and personal default rates in the UK and elsewhere, resulting from slower economic growth, which will have an upward impact on corporate credit spreads.
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