We reaffirm our forecast of a recovery in the US dollar later this year, as the economy avoids recession. Latest data point to strong growth in Q2, though ongoing turbulence in the financial markets related to the US housing downturn is likely to delay the start of the Fed tightening cycle until early next year. Current monetary conditions are loose and, with inflation risks rising, we expect rates to rise by a total of 200bps to end 2009 at 4%.
Our central forecast of weaker oil prices also supports the dollar recovery view.
Summary of main changes to exchange & interest rate forecasts
- We reaffirm our forecast of a recovery in the US dollar later this year, as the economy avoids recession. Latest data point to strong growth in Q2, though ongoing turbulence in the financial markets related to the US housing downturn is likely to delay the start of the Fed tightening cycle until early next year. Current monetary conditions are loose and, with inflation risks rising, we expect rates to rise by a total of 200bps to end 2009 at 4%. Our central forecast of weaker oil prices also supports the dollar recovery view.
- UK business and consumer confidence surveys have deteriorated, suggesting downside risks to growth. Industrial production is likely to have contracted in Q2, yet consumer spending has remained resilient despite falling house prices. We expect the economy to escape recession and, with CPI inflation set to surge above 4% in the coming months, the Bank of England is expected to keep interest rates on hold at 5% in the remainder of the year, but with an upside risk. £/$ is predicted to fall to 1.86 at end-2008 and 1.75 by mid-2009.
- The ECB raised interest rates to 4.25%, but explicitly mentioned “no bias” regarding the outlook for policy, at least for now. Business confidence has fallen, yet our inflation projections show that CPI will surpass 4% in the months ahead. The risk of second-round effects means that we have the ECB raising rates again later in the year. However, the expected recovery in the dollar means we see €/$ falling to 1.47 by year-end and 1.40 in mid-2009. We see £/€ remaining in a narrow range of 1.25-1.27 ahead over a similar period.
- We expect $/Y to stay in a 100-110 range in the coming year. Although Japanese headline CPI and wholesale price inflation have risen, there remains little sign of a pickup in wage inflation. Hence, the BoJ is expected to leave interest rates at 0.5% this year. The Swiss franc is predicted to rise against the euro and pound in the coming year, but only moderately, as the SNB may leave rates at 2.75% this year.
- In the emergers, we expect the Chinese renminbi to continue to appreciate, with $/Cny falling to 6.62 by year-end and 6.45 in mid-2009. Eastern European currencies have performed strongly, but we see some retracement
from current levels, with €/Czk at 25.00 and €/zloty at 3.50, in a year’s time. In Brazil, we see only a moderate correction in the real to $/Brl to 1.72 in a year’s time, given the country’s strong FDI inflows.
Wage inflation is key to whether UK base rates rise
Wage inflation is the key to whether there is a rise in UK interest rates this year. As the Governor said in his open letter to the Chancellor following the rise in annual
CPI inflation to 3.3% in May “it is crucial that prices other than those of commodities, energy and imports do not start rising at a faster rate”. What this means was made much clearer in the minutes of the June MPC meeting at which base rates were kept at 5% by an 8:1 majority, with the dissenter, David Blanchflower, voting for an immediate cut of 0.25%.
The MPC said in the June minutes “There was also a risk that, given the likely squeeze on real income growth as a result of the changing relative prices for energy,
food and imports, employees could respond by raising wage demands. Although wage growth had remained moderate in recent months, surveys indicated that higher inflation had already had an impact on the public’s expectations of inflation, at least in the near term. As such, the Committee continued to judge that a slowdown in activity, reducing pressure on supply capacity and helping to contain wage growth, would be necessary to ensure inflation returned to the 2% target”. The argument for an immediate rise was dismissed on the grounds that medium-term inflation expectations still remained well anchored and that credit constraints and higher
yields were dampening demand. In short, a slowdown in growth was required to help to bring inflation back down to the 2% target in two years and rates would only be raised if the slowdown was not sufficient to slow the rise in inflation. Interest
rates would not be cut just because a slowdown in economic growth was taking place.
Are inflation expectations anchored?
Taken collectively, the MPC seems to think inflation expectations are anchored, saying in the June minutes that “Some comfort could be taken from the relative stability of nominal forward interest rates from five to ten years ahead. If markets had expected
that inflation would persist at high levels, then these rates would most probably have risen". However, we would argue that inflation expectations have risen, as chart a shows. Using breakeven inflation rates (nominal 10 year bond yields minus index
linked), inflation expectations are the highest they have been since the MPC was set up in 1997 (Although issues surrounding demand and supply of index-linked bonds may be clouding the signal). Worse, if consumer inflation expectations are taken
into account, as they should be, they are the highest since the BoE’s own survey started in 1999. In fact, the MPC seems to accept this point in the minutes, which noted that: “inflation would have some tendency to persist above the target if those making decisions about wages and prices began to expect higher inflation in the future”. So the battle against anchoring inflation expectations has already been
lost though it could possibly be regained without too much damage so long as actual inflation falls back quite quickly. This puts even more pressure on the MPC to ensure that wage inflation does not rise and that the pace of economic growth slows down as predicted in the May Inflation Report.