The rapid rise in energy and food prices that has pushed up inflation over the past year is gradually coming to present a wider problem for the Federal Reserve. The Fed normally focuses on core inflation (that is, consumer prices excluding food and energy) in recognition of it being hard to influence (or, for that matter, predict) the typically very strong and short-lived fluctuations seen in food and energy prices. In other words, the Fed considers core inflation to be a better measure of the true course of inflation. This means that more attention will be paid to the negative growth effects of rising food and energy prices than the inflation risks. But this approach relies on an assumption that rising food and energy prices are only a reflection of relative price changes and will therefore not result in more permanent inflation effects. The problem in the current situation is that these price increases have been very persistent and very visible. First, headline inflation has been permanently higher than core inflation for some time. Second, the increase in prices for goods such as gasoline and food has been very obvious to consumers. This means that there may now be an increased risk of inflation expectations in the economy beginning to move. As inflation expectations serve as an anchor for inflation, this could really put the Fed’s credibility to the test - especially in the light of its recent sharp interest rate cuts.
[I] Niels-Henrik Bjørn Sørensen, Senior Analyst, Danske Bank[/I]
[B]Weekly Bank Research Center 06-09-08[/B]
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[B][B][B][B][B] Policy, Commodity Prices and Currencies [/B][/B][/B][/B][/B]
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[I] Stephen Roach, Head Economist, Morgan Stanley [/I]
I believe that the recent rhetoric by US officials – both Treasury Secretary Paulson and Fed Chairman Bernanke – is important, not just for the dollar against other G10 currencies, but also possibly for oil and some other commodity prices. Additionally, if commodity/oil prices are indeed capped by a falling EUR/USD, the USD’s rally could be much more broad-based than many may realise. Could the ECB’s 10th anniversary mark the peak in the EUR? Chairman Bernanke emphasised the costs of a weak dollar rather than its benefits; this is a dramatic shift in Fed policy. Throughout the rate cut cycle, the Fed, not just the chairman, has consistently highlighted net exports as being the only bright spot in the economy. While I believe that much of this outperformance in exports was due to strong external demand, just as German and Japanese exports have also remained strong, despite strong currencies, many Fed officials have credited the role of the weak USD, without proof – an opinion I have never found convincing. In any case, in this speech, Chairman Bernanke shifted the focus from the benefits of a weak USD (strong exports) to the costs of a weak dollar (high imported inflation and rising commodity prices). At a minimum, this implies that the Fed has no intention of cutting the FFR below 2.00% – consistent with the view of our US economists. Firming up the floor in the FFR should, all else equal, be positive for the dollar.
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[B] Federal Reserve’s Credibility Under Pressure [/B]
[/B] [/B] [/B] <em> Niels-Henrik Bjørn Sørensen, Senior Analyst, Danske Bank
The rapid rise in energy and food prices that has pushed up inflation over the past year is gradually coming to present a wider problem for the Federal Reserve. The Fed normally focuses on core inflation (that is, consumer prices excluding food and energy) in recognition of it being hard to influence (or, for that matter, predict) the typically very strong and short-lived fluctuations seen in food and energy prices. In other words, the Fed considers core inflation to be a better measure of the true course of inflation. This means that more attention will be paid to the negative growth effects of rising food and energy prices than the inflation risks. But this approach relies on an assumption that rising food and energy prices are only a reflection of relative price changes and will therefore not result in more permanent inflation effects. The problem in the current situation is that these price increases have been very persistent and very visible. First, headline inflation has been permanently higher than core inflation for some time. Second, the increase in prices for goods such as gasoline and food has been very obvious to consumers. This means that there may now be an increased risk of inflation expectations in the economy beginning to move. As inflation expectations serve as an anchor for inflation, this could really put the Fed’s credibility to the test - especially in the light of its recent sharp interest rate cuts.
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[B] They Said What? [/B]
[/B] [/B] [/B] [I] E. Silvia, Ph.D. Chief Economist, Wachovia[/I]
Two major central bankers made some interesting comments this week. Fed Chairman Bernanke made headlines early in the week when he said “in collaboration with our colleagues at the Treasury, we continue to carefully monitor developments in foreign exchange markets.” Bernanke’s comments were noteworthy, because Fed officials usually refrain from talking about the value of the dollar, leaving that duty to their colleagues at the U.S. Treasury Department. Bernanke went on to say the dollar’s slide could contribute to higher inflation via rising import prices. As shown in the top chart on page 4, overall import price inflation has risen to the highest rate since statistics started to be collected in the early 1980s. Although much of the increase in overall import price inflation is due to the record shattering rise in oil prices, the increase in non-oil import prices, which reflect in part the effects of the weak U.S. dollar, is concerning.
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[B][B][B][B][B] Bank of Canada Expected to Cut [/B][/B][/B][/B][/B]
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[I] Steve Chan, Economist, TD Bank Financial Group [/I]
The Bank of Canada (BoC) has some very mixed signals to sift through then in making its interest rate decision on June 10th. On the one hand, the economy contracted by 0.35% in the first quarter – well below the BoC’s expectation for an expansion of 1.0% – with slower growth in consumer spending, business investment, and residential and nonresidential investment. Meanwhile, exports continued to decline, and with the U.S. economy continuing to slow over the next year, the risks on this front continue to be to the downside. Moreover, core consumer price inflation in Canada is running at 1.5%, below the BoC’s 2.0% target. For these reasons, we believe the BoC will deliver a 25bps cut to bring the policy rate down to 2.75%. Looking forward, the trend in employment growth is relatively unchanged, high oil prices continue to put pressure on prices economy-wide, and the 3-month annualized rate of core consumer inflation is running at 2.9%. None of these is yet suggestive of the need for an immediate and ongoing cycle of rate cuts, and as a result, we believe the BoC is likely to signal at least a near-term pause. However, looking ahead, we believe inflation pressures will not be nearly as pronounced at the three-month trend might suggest. Also, with slack building in the economy as a result of lacklustre GDP and employment growth, the BoC is still likely to cut interest rates further to 2.25% by the end of this year.
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[B][B][B][B][B] ECB Steps Up Fight Against Inflation [/B][/B][/B][/B][/B]
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[I] Trevor Williams, Chief Economist at Lloyds TSB Financial Markets [/I]
Financial markets will still be reacting this week to the strong hint by the ECB that it will raise interest rates at its next meeting in July. Even if the rise does not occur in July, and it looks like it will, the monthly inflation profile suggests that there could be two, not one rise this year. In the euro area, the focus will be on whether the data between now and the July meeting will allow the ECB to raise rates by an expected 0.25%. Figures this week will confirm that CPI is rising but that activity is positive though stalled. However, German and French trade figures will suggest that growth overseas is healthy enough to support exports. EU-15 industrial production, on Thursday, is expected to be positive, up 0.3% after a 0.2% drop in April. French manufacturing output for April, on Tuesday, may show a rise but only at a modest annual rate. However, the industrial and retail sales data this month are unlikely to prevent a rate rise, as they are still consistent with growth of close to 2% a year and so not enough to prevent inflation rising, as in our forecast to well over 4%, as opposed to the fall back expect by the ECB, see charts.
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[B][B][B][B][B] Other Pre-screened Independent Contributors[/B][/B][/B][/B][/B]
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[I] J-Chart [/I]
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