Dollar USA

      Last week I mentioned that though the G8 conference would impact the US dollar in the short term, the ultimate fate of the USD will ultimately be determined more by Bernanke than by anyone else. The Group of Eight’s meeting has come and gone, offering little good news for the USD. In the FOREX market, that “little good news” led to bad news for the USD, as the greenback surrendered some of the territory it had gained last week. So with the conference in the rear-view mirror… let’s look ahead.

     In his most recent column, Robert Novak wrote that despite his publically hawkish stance, Bernanke is more concerned with growth rates. Furthermore, Bernanke feels that oil and gasoline prices, if they continue to rise, could lead to the dreaded state of halted growth in addition to rising inflation. Assuming that what Novak is reporting is accurate, it would seem that Bernanke’s pronouncements last week were a charade. In other words, Bernanke isn’t likely to walk the walk. However, this might not be a bad thing. Many see the economy as not yet ready for a rate hike, and so perhaps holding rates constant for the next several months would be the best thing for the US economy.

     The USD has ended the rally it began last week, and while the short term prospects are dimmer than they were several days ago, the jury is still out regarding the long term. On the one hand, disappointing economic data that keeps coming out (most recently in the US: poor manufacturing results) would indicate that the USD is in for more stormy seas. However, analysts are noting that it has been years since people have held such bullish opinions about the USD. Many feel that the dollar is “due,” meaning that after taking its lumps for years, it is poised to finally recover. With the Saudis agreeing to pump more oil, perhaps the stars are aligning for a USD recovery. However, it’s hard to know the future for certain. As it is written in one of the Harry Potter books, we humans are not very good at reading the stars.

Upcoming Figures

AUD Reserve Bank of Australia’s Board Minutes (Jun)

EUR Italian Trade Balance (Euros) (Apr)

GBP Consumer Price Index (May)

EUR Euro-Zone Trade Balance (Euros) (Apr)

USD Current Account Balance (Q1)

USD Housing Starts (May)

JPY BoJ to Publish Minutes of Board Meetings

FOREX-Euro, Aussie fall on Greece, global economy worries

             In the days leading up to the European Central Bank’s rate decision on July 3rd, 2008, many political leaders around Europe publically pleaded for the ECB to leave interest rates unchanged. Among others, French President Sarkozy voiced the opinion that the recent rise in inflation was due primarily to the spike in commodity prices.¹ As such, Sarkozy suggested that though hiking interest rates would not really help in lowering inflation, it would adversely impact growth. The ECB went ahead and hiked interest rates anyway, and looking back now, a month and a half later, we can begin to asses two issues: whether the rate hike was the right choice, and what the ECB should do now.

        Looking at the statistics over the past few months here, there are several main points to take away. The first is that President Sarkozy’s nightmare seems to have become reality; growth has suffered. In the Euro-Zone, as well as in its three largest economies, Gross Domestic Product (GDP) fell in the second quarter. However, the second chart (showing Consumer Price Index) indicates that inflation has either slowed or halted its rise in these same economies.

       Given that the ECB is bound to target inflation first and foremost, the above statistics would imply that the recent rate hike was the correct move – though clearly not without consequences. Inflation has slowed in its rise, and while next months’ numbers will bring about more clarity to the situation, it seems that the rate hike had its desired impact. Now, the more prudent question is if the long-term repercussions of the hike will outweigh the benefits. Will the rate hike facilitate Europe’s slide into recession? It is certainly possible. Italy is already on the brink of recession, and France’s large decline in growth indicates that it is also in trouble.

      One important note about the CPI numbers is regarding the source of the recent slowdown in the rise of inflation. As the price of oil started to fall around the same time as the rate hike, it is unclear which – or both – influenced inflation. As it is probable that both events have had an impact, it is unknown just how useful the rate hike has been thus far in thwarting inflation’s rise. However, considering the magnitude of oil’s fall in recent weeks, it is safe to assume that it has had a sizeable impact on the slowing of the rise of inflation. The fall in oil price will help alleviate inflationary pressures anyway; hence the ECB should switch focus to the other problem of falling growth.

At this point, the best move for the ECB would now be to cut rates. While the ECB was founded with an inflation-targeting mentality, it is too dangerous to ignore growth at this time. The US (seemingly) has recently skirted around a recession by aggressively slashing rates and supporting wounded members of the banking system. By admitting the problem early on, the US avoided significant damage to the financial sector, with only one of the largest banks going under. Europe, however, has taken a different path, and now finds itself on the precipice of recession. This proposition to focus on spurring growth comes from the belief that the inflation problem can largely solve itself as long as energy costs continue to fall. With oil prices down over 20% from their all-time high, it seems apparent that this fall in price will eventually be filtered down to consumers.

     Proponents of the ECB’s generally “hawkish” nature would certainly throw out economic theories such as the J-Curve to support their position. This theory suggests that through a devaluation, a country can actually increase their trade balance (and hence GDP) via increased exports and decreased imports. There is potential for this to occur, but that would involve a devaluation of the Euro that many Europeans would certainly love to avoid. Furthermore, this process of GDP rising on its own could take an unacceptable length of time. Just recently, the ECB finally admitted the problems that the Euro-Zone now faces.² It is time that the ECB make a bold move and cut rates, sending a signal to the markets that they will not stand by and watch Europe sink into recession.