US Fed - Paying Lip Service

[B] Yield Spread Analysis 03/20 – 03/27

[/B]While much has been made of the shift of the US yield curve to normal from inverted as the 2yr-10yr spread turned positive, even shorter term rates (3 months) have remain elevated on the continued hawkish bias of the Federal Reserve. Their slant has been somewhat surprising to some as signs of slowing growth frequently emerge from not only the housing sector, but in manufacturing and consumption as well.

Furthermore, some analysts have taken the move of the spread into positive territory as a sign that recession probabilities have been slashed. However, looking at yield spreads around the world, it’s clear that the market’s slow move away from risk aversion has led nearly all bond prices lower, with longer term bond yields the main beneficiary. This has occurred even in Japan, where the central bank is widely anticipated to leave their benchmark steady at 0.50 percent for much of the year as consumption and wage growth remain tepid.

Looking forward, bonds prices could see a resurgence as mounting geopolitical tensions in Iran, where 15 British soldiers were taken captive, could lead traders to engage in flight-to-safety and bring global yield curves lower once again.

US Fed – Paying Lip Service
With core prices picking up, Fed officials have expressed the need for vigilance against inflation despite the fallout of subprime lenders and other signs of slowing expansion:

Michael Moskow, Federal Reserve Bank of Chicago President (Voter)
“Our best estimate is that it is in the process of stabilizing and that by the second half of the year, housing will start to pick up again.” – March 26, 2007

“My assessment is that the risk of inflation remaining too high is greater than the risk of growth falling too low. I prefer inflation to be between 1 percent and 2 percent. Given an uptick in some inflation measures so far in 2007, it is much too early to say that inflation is no longer a concern.” – March 27, 2007

Frederic Mishkin, Federal Reserve Board Governor (Voter)
“I am less optimistic about the prospects for core PCE inflation to move much below 2 percent in the absence of a determined effort by monetary policy.” – March 26, 2007

Charles Plosser, Federal Reserve Bank of Philadelphia President (Non-Voter)
“Recent data on US inflation has not shown price pressures abating, and the Federal Reserve needs to stay vigilant.” – March 23, 2007
However, a former central banker thinks the divergence of growth and inflation will keep rates at 5.25 percent:

Robert McTeer, Former Federal Reserve Bank of Dallas President
“There are people calling for ease and people calling for tightening, and both sides can make a reasonably good case. So I think that’s going to freeze them in place.” – March 21, 2007

ECB – Is 3.75% Truly Accommodative?
Members of the European Central Bank’s MPC have made it clear that they still intend to work to combat inflation, but do they have the impetus to go so far as to raise the Euro-zone’s benchmark to 4.00 percent?

Jean-Claude Trichet, European Central Bank President
“In the governing council’s view, the risks surrounding this favorable outlook for economic growth are broadly balanced over the shorter term. At longer horizons, risks lie mainly on the downside, relating to the possibility of a renewed increase in oil prices, fears of a rise in protectionist pressures and concerns about possible disorderly developments owing to global imbalances.” – March 21, 2007

Nicholas Garganas, European Central Bank Governing Council Member
“I would not say that interest rates have reached a level that could be described as a peak?If we assess that inflation risks are on the upside and jeopardize price stability, we will act to ensure price stability. There’s nothing sacrosanct about the level of interest rates.” – March 27, 2007

[U]Klaus Liebscher, European Central Bank Governing Council Member

[/U]“We see, if I may say so, certain clouds on the horizon for the end of the year and for 2008 concerning inflationary developments?so altogether, I think we are not well advised to be too complacent.” – March 27, 2007

Erkki Liikanen, European Central Bank Governing Council Member

“The policy rate is now 3.75 percent and monetary policy continues to be on the accommodative side?the Governing Council will monitor very closely all developments so that risks to price stability over the medium term do not materialize. These risks remain on the upside, relating in particular to stronger than currently expected wage developments.” – March 20, 2007

BoE – No Consensus
While Bank of England Governor King is still concerned about headline inflation figures, ultra-dove Blanchflower foresees rapidly declining price pressures:

Mervyn King, Bank of England Governor
“The news in the unexpected fall in inflation from 3 percent to 2.7 percent in January was largely offset by the subsequent unexpected pick up to 2.8 percent in February.” – March 27, 2007

David Blanchflower, Bank of England Monetary Policy Committee Member

“The degree of monetary tightening, in conjunction with benign wage inflation, had started to push down consumption and housing market activity. Inflation was likely to decline faster in the short-term than in the Committee’s central projection.” – March 21, 2007

The usually-dovish Barker, on the other hand, suggests that more frequent adjustments to monetary policy may be necessary to deal with price changes:

Kate Barker, Bank of England Monetary Policy Committee Member
“For inflation, while short-term uncertainty is mainly due to the domestic energy market, and may be resolved over the next few months, the medium-term uncertainty is more pervasive. I suggest that this may prompt a change in observed behavior towards more frequent interest rate changes.” – March 21, 2007