Markets were captivated this week by U.S. dollar comments from Fed Chairman Ben Bernanke, in which he expressed concern over the U.S. dollar's decline contributing to "unwelcome" increases in import prices, and hawkish comments from European Central Bank President Jean-Claude Trichet suggesting a hike at the bank's next policy meeting is a possibility.
Bernanke's remarks that the Fed is "attentive" to the slide in value of the U.S. dollar caused the greenback to surge on Tuesday. It lost ground again on Thursday when a hawkish Trichet suggested the ECB will hike rates at its July meeting.
The timing of the comments caused some to speculate about co-ordination between the central bank heads.
"The market had just about built up enough confidence in the USD to run up a decent short EUR position and the ECB pulls the rug out from under it with a virtual rate hike," observed Shaun Osborne, chief currency strategist at TD Securities. "The assumption was that perhaps the Fed and the ECB could do with picking up the phone now and again, but perhaps they did, and the Bernanke comments earlier this week were cushioning for what he assumed would be a pounding for the USD as the ECB dialed up the rate hike rhetoric."
However, not all agree, with Steve Malyon of Scotia Capital talking about evidence of a "discord" between the two banks in a note to clients. "The Fed would like to see the USD higher, but with the ECB preoccupied by inflation and evidently disinclined to test the theory that a stronger USD might actually help it meet its inflation objectives (by stabilizing crude oil prices), the threat of a coordinated intervention suddenly looks smaller," he wrote.
This past week also saw three major central banks leave their rates on hold - the ECB, the Reserve Bank of Australia and the Bank of England all left their key overnight lending rates unchanged this month, citing slowing economic conditions and runaway inflation.
Looking to the week ahead, the Bank of Japan is expected to follow suit and leave its key interest rate at 0.50% when it meets on Friday, while markets are now fully priced in for at least a 25 basis point cut from the Bank of Canada on Tuesday.
U.S. Federal Reserve
Current Rate: 2.00%
Next Rate Decision: June 25
Market Expectations: According to Fed Funds Futures, markets are pricing in a 100% chance for rates to remain on hold at the next meeting.
In a rare comment from a Fed chairman on the U.S. dollar this past week, Bernanke said the Federal Reserve is "attentive" to the slide in value of the U.S. dollar and that it has caused an "unwelcome" rise in import costs. He also said that interest rates are currently "well-positioned" for growth and stable prices and that the Fed will "act as needed" to meet the bank's mandate relating to both growth and prices.
"The fact these dollar-supporting remarks have emerged from an institution with the means to control interest rates is somewhat unprecedented in the current Fed and bears the signs of the central bank's bid to support the U.S. currency," noted Ashraf Laidi, chief currency strategist at CMC Markets.
On Wednesday, Bernanke said overall inflation is significantly higher than he would like, but less than the 1970s-style stagflation. Bernanke said he didn't expect to see the long lines for gas seen in the 1970s, but acknowledged the burden high gas prices have had for many households.
Other Fed speakers this week included Vice Chairman Donald Kohn, who warned that banks need to strengthen reserves in order to improve liquidity, while speaking before the Senate Banking Committee in Washington, D.C. Kohn told the committee that bank reserves have not kept up with rising problems and that the problems may extend to consumer loans.
Speaking on financial stability in London, Richmond Fed President Jeffrey Lacker (non-voter) said he called on the Fed to detail its rules on intervening in the financial markets in order to minimize moral hazard and greater risk taking. Lacker also said that the Fed could contribute more to financial stability by fighting inflation which, after falling in February and March, has since stabilized. On economic growth, Lacker maintained that the slowing U.S. economy should gradually recover over the next twelve months and return to its long-term trend by mid-2009.
Philadelphia Fed President Charles Plosser delivered a similar speech in New York, saying the Federal Reserve must follow rules and exercise caution as a lender of last resort. Plosser said benchmarks may be needed to properly determine situations that qualify as system risks and that interventions to calm the markets run the risk of moral hazard and inhibited price discovery.
On Monday, Atlanta Fed President Dennis Lockhart (non-voter) said the U.S. economy continues to face significant uncertainty and risks, but that he expects an improvement in growth in the second half of the year. Speaking to the Jacksonville Chamber of Commerce, Lockhart said inflation is at uncomfortable levels, with some indications of rising expectations. He noted the current elevated level of inflation will begin to ease as food and energy prices moderate. Lockhart suggested that it could take some time for the Fed's monetary policy easing to be felt, but said the current stance was appropriate and adequately addressed the risks to the economy.
Looking ahead, Bernanke will deliver a speech titled 'Outstanding Issues in the Analysis of Inflation' at the Boston Fed's annual research conference on Monday.
Bank of Canada
Current Rate: 3.00%
Next Rate Decision: June 10
Market Expectations: Markets are fully priced in for at least a 25bp cut. (OIS Implied rate)
Markets are fully priced in for a 25 basis point rate reduction by the Bank of Canada on Tuesday, particularly after employment data released on Friday showed a dramatic slowdown in job growth in May.
"Canadian employment is finally showing visible signs that the downturn in the U.S. is beginning to be felt in the domestic economy," noted Apekhsa Sumaria from ING. "And this is in spite of the 150bp of pre-emptive easing delivered from the BoC. As such, we believe there is a strong case for the BoC to ease rates, albeit at a less aggressive pace, to 2.75% when it meets to set policy on Tuesday."
Douglas Porter, deputy chief economist from BMO Capital Markets, noted that the report is broadly neutral for the outlook, with the job gain mostly owing to its reliance on factory payroll growth and wages "suddenly re-emerging as a potential problem again".
"While unlikely to make a big dent in next week's decision by the Bank of Canada, (Friday)'s result does raise the probability that the rate cut cycle is rapidly nearing an end - between higher-than-expected CPI inflation, soaring oil prices, strong wages and a job market that isn't falling apart, the Bank is unlikely to cut rates much further," he said.
On Thursday, the C.D. Howe Institute's shadow monetary policy council recommended the BOC leave its rate at 3.00%. Just three of the members recommended that the bank lower its rate by 25 bps, five members recommended a hold, one member called for a 25bp hike and two voted for a 50bp hike.
Reserve Bank of Australia
Current Rate: 7.25%
Next Rate Decision: July 1
Market Expectations: 22% chance of a 25bp hike (OIS Implied rate).
The main news from the Reserve Bank of Australia this week was its decision to hold the key lending rate at 7.25%. The accompanying statement was nearly identical to the one released following the May decision.
In his statement, RBA Governor Glenn Stevens said, "Inflation in Australia has been high over the past year in an environment of limited spare capacity and earlier strong growth in demand. In these circumstances, the Board has been seeking to restrain demand in order to reduce inflation over time."
Economists noted the statement was very similar to the text released in May, with just one paragraph materially different. "This suggests that the RBA Board viewed the policy environment as largely unchanged, with short-term upside inflation pressures contrasted with expectations for medium term slowing demand," noted Joshua Williamson, a senior strategist at TD Securities.
While the May statement noted weaker demand for credit, the June statement added the word "significantly," Williamson observed, adding it appears the RBA is giving more consideration to the downside risks of economic activity.
The minutes of the June meeting are scheduled to be released on June 17.
European Central Bank
Current Rate: 4.00%
Next Rate Decision: July 3
Market Expectations: 99% chance of a 25bp hike (EONIA Implied Rate).
Following the European Central Bank's decision to hold rates at 4.00% on Thursday, ECB President Jean-Claude Trichet caught markets by surprise with his hawkish comments that all but confirmed the likelihood of a rate hike at the bank's next meeting.
Trichet noted the risks to price stability in the medium term had increased further, emphasizing that inflation rates had risen "significantly" since last year and would remain at elevated levels for a more protracted period than first thought.
With the upside risks to price stability confirmed, Trichet stressed that the ECB was "monitoring very closely" all events and that the central bank was "in a heightened state of alertness". Trichet also disclosed that some Governing Council members believed there was a case for raising rates at the June meeting.
While answering questions from reporters, Trichet acknowledged that the vote to keep rates at 4.00% was not unanimous and that some Governing Council members had pushed for a rate increase.
Most investment banks immediately changed their forecasts to expect a rate hike from the ECB at its July meeting.
Shortly after Trichet's press conference, Bundesbank President Axel Weber added to that expectation by saying markets should prepare for a policy response to the building inflation pressures in the euro zone. The ECB sent a clear message today, Weber said, citing earlier hawkish commentary from Trichet.
"We think that the central bank will - in an attempt to try and push expectations back down - step up its hawkish rhetoric," said Nick Kounis, a senior economist from Fortis. "The chances that this type of verbal intervention will work look limited given that inflation expectations have been trending higher over recent weeks, even though financial markets have been pricing in increased chances of rate hikes."
Speaking in Rome on Friday, French Finance Minister Christine Lagarde said the ECB does not usually pre-announce rate decisions.
On Wednesday, speaking at the OECD conference in Paris, Trichet emphasized the importance of market stability, adding that the ECB's liquidity injections were providing that stability and were serving markets well. Trichet also underlined the distinction between maintaining price stability and providing the necessary liquidity to markets.
One day earlier, Trichet said the global economic situation was challenging and that the disinflationary effects of low-cost nations were decreasing. Trichet said that inflation remained a monetary phenomenon and reiterated the necessity for maintaining price stability. He added that European central bankers felt vindicated in keeping their focus on headline rather than core inflation given the recent gains in oil prices.
Luxembourg Finance Minister Jean-Claude Juncker also spoke on inflation earlier in the week, saying second-round inflation effects must be avoided and that vigilance on inflation must be maintained. Juncker called the International Monetary Fund's forecast on inflation somewhat optimistic, adding that the IMF believed in the resiliency of the euro zone economy.
In an interview with French website Mediapart, European Central Bank President Jean-Claude Trichet stated that "complacency was out of the question" and warned against repeating the mistakes made during the energy crisis of the 1970s. He also said that central banks must target inflation in their monetary policies. While calling the market crisis a "challenge of great magnitude", Trichet emphasized that the ECB has weathered the effects of the market rout and that he saw markets gradually returning to normal.
The European Central Bank expects inflation to return to the 2% target rate in the medium term, ECB Executive Board member J?Stark stated in an interview with German radio station Inforradio aired on Monday.
Bank of England
Current Rate: 5.00%
Next Rate Decision: July 10
Market Expectations: 37% chance of a 25bp hike (SONIA Implied Rate)
As expected by economists and market participants, the Bank of England left the bank rate unchanged at 5.00% on Thursday morning as the country faces the combined effects of slowing economic growth and soaring inflation.
In the Bank of England's May inflation report, the UK central bank said it expected the annual CPI inflation rate would rise to around 3.5% to 3.7% by fall 2008, mostly on the back of rising energy costs.
Raymond Van der Putten of BNP Paribas said the bank's decision is "unlikely to have been taken unanimously."
"In particular, David Blanchflower is likely to have favoured a 25bp reduction, as he expects price pressures to disappear gradually in the coming quarters as the economy slows. However, as inflation could rise to 4% soon, it will be an uphill struggle for him to convince the other MPC members," he said. "Hence, the Bank of England is certainly to keep (the) Bank Rate at 5% in the near term."
Bank of Japan
Current Rate: 0.50%
Next Rate Decision: June 13
Market Expectations: 96% chance of a hold, 4% chance of a 25bp hike (OIS Implied Rate).
It was another quiet week for the Bank of Japan.
On Tuesday, Bank of Japan Governor Masaaki Shirakawa said central banks are facing a "difficult balancing act" with rising global inflation pressures and downside growth risks, and added that monetary policy at the BOJ had been "extremely accommodative."
Despite slowing economic growth coupled with downside risks, the central banker nevertheless expects the Japanese economy to recover in late 2008 or early in 2009 on the back of supportive consumer spending and an increased resiliency of the economy.
By Stephen Huebl and edited by Nancy Girgis