Highlights
Markets have firmly priced in another interest rate cut in the US at end of October
Inflation risks could revive interest rate hike speculation in the EMU
Divergent monetary policy signals from the US and the EMU
At the G7 meeting, finance ministers had called for an accelerated appreciation of the Chinese renminbi. After China reported on Thursday that growth had remained strong in the third quarter with an 11.5% increase year-on-year, the renminbi appreciated substantially due to increased speculation that interest rates would be raised. At 7.4820, it reached its highest level against the dollar since giving up the dollar peg in July 2005.
Contrary to expectations, the G7 representatives did not comment on the dollar??™s weakness, whereupon EUR-USD jumped to a fresh all-time high of 1.4348 on Monday. Subsequently, risk aversion increased again significantly, prompting profit-taking and the unwinding of carry trade positions, which supported the dollar for a while. Having reached a two-week high of 1.4127 for a short time, the US currency weakened again during the course of the week: after it was reported that US durable goods orders had unexpectedly fallen again, the euro climbed to a new record high of 1.4374 on Friday.
The Fed is expected to cut interest rates to support economic growth. Apparently the Fed also sees the housing market weakness as the main risk to the economy. In contrast, given the unfavourable development of inflation in Germany, Axel Weber, president of the German Bundesbank, has indicated that further tightening of refi rates might be necessary in the EMU.
The main reason for the US central bank cutting the Fed funds rate substantially by 50 basis points on 18 September was to prevent the housing crisis from spilling over into other sectors of the economy. After that, market expectations of a further rate cut on 31 October had declined significantly for a while, particularly as the September labour market figures turned out to be much better than expected, due to the upward revision of the two previous months. However, Fed funds futures are now pricing in a 100% chance of a rate cut on 31 October again; most market observers are expecting a 25 basis point cut to 4.5%.
The Open Market Committee could well cut interest rates next week, for a number of reasons. Although the pressure on the money market has subsided somewhat, the freezing up of some market segments will nevertheless have a noticeable impact on the real economy. According to FOMC member Randall Kroszner, the Fed will have to take this into consideration in its policy decisions, particularly as, in his view, it will take a long time for the credit markets to recover.
Another FOMC voting member, Charles Evans, considers the worsening of the housing market crisis as a serious risk because the possible consequences might be disastrous. The latest existing home sales data illustrate vividly how weak the construction industry is: in September sales fell much more sharply than the consensus had expected, plunging to a record low of 5.04m; after dropping steeply, the median price is now down 4.2% compared to last year. As it would now take 10.5 months to sell existing homes on the market, it looks as though residential construction will not stabilise for a very long time to come.
And in his speech entitled ???Monetary Policy Under Uncertainty???, Fed chairman Ben Bernanke indicated that in high economic-risk situations, bigger monetary policy steps could be necessary. Despite the fact that next week the advance GDP estimate for Q3 will probably show that the growth rate has remained quite stable at around 3% annualized, economic momentum had already slowed down noticeably over the summer months. In Q4, growth is likely to virtually come to a standstill as a result of weakening consumer and investment activity. Consequently, we are expecting next week??™s October US labour market data to be disappointing too.
In its press release, the Fed will probably reiterate that it is remaining vigilant as inflation risks still persist because of the dollar depreciation and the high energy prices. However, as the PCE deflator has developed favourably, the Fed can concentrate on the growth risks: in August, the core deflator had declined to 1.8%; in September, it will either have remained stable or might even have fallen slightly again to 1.7% (data due to be released on 1 November).
In the eurozone, however, the central bank??™s focus is on the inflation rate including food and energy prices. According to Axel Weber, the German harmonized inflation rate could reach 3% by the end of the year. In September, German HICP was 2.7%, and it is not likely to fall slightly in October as initially expected, but might instead go up further. This is largely because of a basis effect related to energy prices, but this effect will become even more pronounced due to the sharp increase in crude oil prices. According to preliminaryGerman regional price data for October, food prices have increasedmost. Mr Weber pointed out, however, that it is not just food andenergy prices that are rising, but that the increase is now more widelyspread. Given the concern about inflation, financial markets could start speculating as to whether the ECB might just have postponed a further rate rise because of market turmoil, rather than having given up on the idea altogether. However, EMU economic indicators are for the most part indicating an economic slowdown. Although the German Ifo business climate index only fell moderately in October, from 104.2 to 103.9, expectations have been declining quite significantly since the middle of the year.
In addition, not all ECB representatives are as hawkish as Mr Weber. According to ECB Council member Jos?© Manuel Gonz??lez-P??ramo, price stability risks do not have to be reassessed if the increase in inflation is mainly due to temporary basis effects. He moreover pointed out that monetary and borrowing conditions had become more restrictive and that economic uncertainty had increased despite still solid data.
We continue to think that growth risks for the euro area are being underestimated at the moment. But given the current inflation figures, it seems unlikely that the ECB will cut the refi rate at one of the next two meetings. Since the interest rate spread will therefore narrow initially, the euro is likely to remain well supported against the dollar in the coming weeks.