Short-term interest-rate differentials can explain the dollar’s movement — especially for the critical euro-dollar relationship (see “The dollar super-cycle,” Currency Trader, March 2006).
Between early December 2006 and late January 2007, the market took back the nearly 50 basis points (bps) in Federal Reserve rate cuts it had priced in to the term structure, even though the Fed on numerous occasions indicated that, from its perspective, the upside risk of inflation was greater than the downside risks to growth. The euro pulled back nearly a nickel as the interest-rate expectations were adjusted.
The pendulum of market expectations swung as far as macroeconomic performance would allow. By the middle of February it became clear the preliminary estimate of U.S. Q4 GDP of 3.5 percent would be subject to a substantial downward revision to reflect new trade, inventory, and construction data. Moreover, on balance, indications point to growth in the 2.0- to 2.5-percent range for Q1 2007. The easing of short-term U.S. rates and the narrowing differential with the Eurozone, where growth appeared more solid in Q4, was accompanied by a down move in the dollar.
In his semiannual testimony before Congress, Federal Reserve Chairman Ben Bernanke appeared more confident current policies would foster sustainable growth and the gradual ebbing of core inflation — the picture- book definition of an economic “soft-landing.” While housing still posed a risk to growth, the greater risk remained that core prices would prove sticky.
Bernanke, who has eschewed the strategic ambiguity of his predecessor, Alan Greenspan, was clear: While there were some indications inflation pressures were beginning to moderate, the data was noisy and “it would be some time before we can be confident that underlying inflation is moderating as anticipated.” The unequivocal message from the Federal Reserve is that inflation is decidedly on hold.
Although not without critics, Bernanke’s first year at the Fed’s helm compares quite favorably with his two immediate predecessors. And even with one of the most inexperienced Federal Reserve Boards in history, its economic forecasts have been uncannily accurate.
The most significant exception was the continued strong performance of the U.S. labor market. The jobs data has been subject to substantial revisions that often make the initial reports quite unreliable. The government initially estimated that 3.3 million jobs were created between March 2005 and December 2006 but, upon review, the government found another million jobs. The strength of the labor market is the key to consumer spending, which accounts for nearly 70 percent of the economy. Despite weakness in home prices and a startling 19.2-percent collapse in residential construction, real consumer spending in Q4 grew at a 4.4-percent annual rate, the second-strongest quarterly performance in three years.
Moreover, in the recent past, the real fed funds rate (currently around 3 percent) has needed to be higher than prevailing levels to sustain non-inflationary growth. In 1994- 1995, the real rate was closer to 4 percent, and in the 1999- 2000 period, it reached 5 percent. If monetary policy acts with a six- to nine-month lag, the effect of the Fed’s tightening through mid-2006 should be diminishing just as the drag from the housing market, autos, and inventory adjustments are starting to decline.
Assuming the economy returns to the path of trend growth as the Federal Reserve forecasts, the tightening cycle might resume in late Q3 or early Q4.
Subscribe to:
Post Comments (Atom)
Post a Comment