03:49 2007/04/18
Soft CPI Shows Real Rates at 6-year High
The dollar sells off sharply across the board on a combination of unexpected decline in industrial production and softer than expected inflation. US CPI grew 0.06% in March, its lowest rate since April 2005, further placing the Fed??™s inflation rhetoric in doubt and leaving the market to worry about slowing growth. The year on year core CPI dipped to 2.5% from 2.8%, its lowest rate since May 2006.
Industrial production fell 0.2%, when it was expected to remain flat, while capacity utilization fell to 81.4% from a downward revised 81.6% (prev 82.0%).
The unexpected 0.8% increase rise in March housing starts to 1.518 mln overshot forecasts of 1.52 mln, was partly offset by the downward revision in February starts to 1.506 mln from 1.525 mln.
Markets were already skeptical of the Fed??™s persistent rhetoric that inflation is the predominant concern at a time of deteriorating conditions in housing and manufacturing. Today??™s softer than e expected inflation will give currency traders more reason to move into euros and sterling, where the inflation and the growth case remains justified for further tightening. The chart below shows that with the fed funds rate at 5.25% and annual core CPI at 0.06%, the real fed funds rate is now at 2.77%, the highest level since March 2001. This may run counter to claims from investment strategists indicating surging financial liquidity via the pace of mergers and private equity deals.
While 2.5% core CPI remains at the top of the Fed??™s inflation comfort level, the decline from the 3.0% levels (September 2006) and 2.8% levels (October 2006 and February 2007) supports the previous historical pattern of slowing inflation along with slowing economic growth. As we had mentioned before, inflation did not begin its real retreat until after the Fed began easing.
Today??™s report also affirms the fact that rising US inflation has been largely a result of rising housing rents, which account for 41% of the entire CPI basket. The 3-month growth in the housing component rose 3.5% in March, from 3.4%, 3.8% and 2.8% in December, September and June respectively.
Today, $2.00 sterling reflects more than just high UK inflation. Sterling ??™s rise to the $2.0 level for the first time since September 1992 is an important landmark in the high yielding make up of currency carry trades as well as a key development in the weakness of the US dollar. The unprecedented 3.1% growth in UK inflation in the newly independent central bank (since May 1997), which cements expectations for UK rates to rise to 5.50% next month, surpassing their US counterpart for the first time since January 2006. EURUSD fell short of breaching the 1.36 figure, but the figure now seems inevitable for the week, with the 1.3676 all time high a viable target before month end.
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