NEWS / Foreign Exchange

Pullback in inflation does not mean all-clear for the ECB

• Relief? Inflation in the eurozone was lower recently than previously anticipated. This holds true primarily for Germany, where inflation remained tame after the VAT hike ??“ even though the tax increase was, as expected, passed on to the consumer. Lower energy prices succeeded, however, in more than offsetting the tax effect.
• All-clear? We are, therefore, lowering our inflation forecasts for 2007. By the middle of the year, EMU-wide consumer price inflation will even slow to 1??% and, therefore, be well below the ECB??™s target again. This does not, however, signal an all-clear for the ECB! The pullback in inflation is merely temporary, being driven primarily by oil price developments. Underlying inflation as measured by the core rate, in contrast, continues to trend higher (cf. chart below).
• Pressure. The ECB??™s main concerns on the medium-term inflation outlook are the ongoing rise in service prices driven by strong domestic demand, emerging wage cost pressure as well as the still strong money supply growth.
• ECB. The increase in the refi rate to 4% at the beginning of June is, therefore, considered pretty much a done deal. At the same time, the risks for further rate hikes thereafter are rising steadily.

Further topics:

• Weekly Comment: FOMC statement ??“ the sibyl curse.
• Fed: Why it will not change its key rate this year.
• US: Healthy corporate balance sheets, but less capex growth.
• Inflation-linked bonds: German vs. French inflation.
• Data outlook: Ifo to weaken, while Italian business climate to be unchanged; US PCE deflator substantially higher.
• Market outlook: USD under pressure; bonds to move sideways.

THE SIBYL CURSE

It is ironic. Greenspan had become famous for his cryptic pronouncements, which spawned a number of hilarious anecdotes (he reportedly had to propose thrice before his wife-to-be understood him). Bernanke, by contrast, had immediately been perceived as championing a much more transparent communication style. Nonetheless, after Wednesday??™s FOMC statement, the markets found themselves wondering whether the Fed had dropped its tightening bias or not, with analysts offering subtle characterizations such as ???soft tightening bias??? or ???implicit tightening bias???, or again ???qualified tightening bias???.

The debate centers on two key interconnected questions: Does the Fed still have a tightening bias? Or is there a ???Bernanke put???? Our answer to the first question was already clearly laid out by Roger Kubarych in his flash comment on the FOMC statement: the Fed has dropped the specific threat of further tightening, but has reiterated that its focus at this stage remains on inflation, which it referred to as its predominant concern. In a sense, the Fed has transparently communicated uncertainty: recent data on the housing market and, more importantly, investment, have underscored that the current soft patch is likely to continue, with somewhat more obvious downside risks. In our view, the removal of the explicit tightening threat is just an overdue cleaning up of the language in the statement: given the FOMC??™s baseline view that growth has slowed to a more sustainable pace and inflation pressures are set to moderate, there already was no obvious case for further rate hikes. We always saw the reference to possible further tightening as a way to keep inflation expectations anchored and prevent a sudden back-up in longer-term yields??”and indeed the focus on inflation is confirmed in the latest version of the statement.

Bottom line: the Fed??™s policy stance has not been

substantially altered, its sanguine view of the economy still stands, together with its determination to keep inflation and inflation expectations in check.

This, however, is not the same as saying that we can count on a Bernanke put, i.e. assume that the Fed stands ready to intervene to prevent any sharp drop in asset prices. True, the Fed has given a clearer signal that it is monitoring both inflation and growth, not just inflation??”but this is just restating what should have been obvious in the first place.

The market has reacted by pricing in 50 bp in rate cuts for the remainder of the year, with a first cut by June. We see this as a gross overreaction: unless one has a substantially more pessimistic view on nearterm growth developments than the Fed??™s, the odds of a rate cut seem quite low. We stick by our view, and expect the Fed to remain on hold for the remainder of this year.

The boost to bonds should therefore prove shortlived, with economic data in the coming weeks leading to reduced rate cut expectations. The changed tone of the FOMC statement, however, should provide more durable support to riskier assets: stronger confidence that the Fed could intervene promptly if activity were to decelerate sharply should prove constructive for equities; in the FX universe, higher yielding currencies should benefit; and risk takers in EM should be heartened, although still with a discriminating eye keenly trained on fundamentals. In our home EEMEA region, Turkey stands out as a higher-beta market currently enjoying positive news on the FDI and current account front.

Investors would be well advised, however, to take a hint from the Fed and not write off the inflation danger too quickly. A sudden rise in inflation would open the quickest way towards a faster reabsorption of liquidity and a sudden collapse of risk appetite.