- Equity fears

- Central Bank prescriptions

- The 'decoupled' world economy?

The question for the currency markets is what degree of American economic weakness is priced into the current dollar level. It is not a question that can yet be conclusively answered. But it will, over the next two weeks be demonstrated, as figures for December on US Retails Sales, Durable Goods, and inflation (CPI and PPI) are issued and the market responds.

US statistics have not yet confirmed the considerable worry over a consumer led recession that has infected the equities market. If there is one thing holding up--a relative term—the dollar it is the fear that where the US economy leads the rest of the world is sure to follow. Some amount of US economic pullback has been the operating assumption since the sub-prime financial mess blew up this past August. If the US falls to recession the restraint on the euro this week argues that a sympathetic slowdown in the rest of the world is very much on the minds of currency traders.

All of the world's major central banks agree on the economic diagnosis, but the prescriptions differ widely. Three major banks had their say this week, the European Central Bank (ECB) and the Bank of England (BOE) with their decisions to hold their current rate structure and the Federal Reserve with Chairman Ben Bernanke promising substantial action as needed. In the present economic context a 50 basis point cut at the end of the month if not sooner is now the default Fed position.

The world economic situation is in flux. The basic assumptions of the currency markets which have benefited the euro, the commodity currencies and the pound sterling for six months are under strain. They will not survive the prospective US slowdown or recession and it by no means assured that the dollar will not be the ultimate beneficiary.

Central Banks


According to Jean Claude Trichet the president of the European Central Bank, the board of governors debated a rate hike prior to their decision to leave rates unchanged at 4.00% Thursday. He made no mention of consideration of a rate cut. The omission was deliberate. If the bank's decision was fully expected, so was the attendant anti inflation rhetoric. There is no reason to doubt the ECB governors' concern about inflation.

In Germany the Verdi trade union is negotiating a wage package for more than 2 million workers and asking for an 8.0% increase. These are the second round effects the ECB has often mentioned. The ECB wants to reassure workers and consumers that it will keep a rein on inflation to help defray the pressure for large wage settlements. I said on behalf of the governing council that we were prepared to act preemptively so that second round effects on upside risks to price stability would not materialize and consequently that inflation expectations would remain anchored, said Mr. Trichet. He reaffirmed the tightening bias of the bank, We certainly are not neutral it a good interpretation of what I said. He also made a point of separating the problems in the money markets and the bank's response to them, the risks as far as we see them stemming from a numbers of factors including this [market] correction are on the downside. We are seeing signals that are…very mixed. Tensions in the interbank markets are probably unavoidable and probably a necessary correction We make totally the difference between what we have to decide to deliver price stability...to anchor solidly inflationary expectations, and then that being decided, we have to care for the money market behaving properly. German workers particularly, but European employees in general, have not pressed for large wage hikes in the past few years, that may be about to change.

It is not necessary for the ECB to cite burgeoning economic worries. With the frequency and stridency of its anti- inflation rhetoric, and its constant waning that it can and might boost rates to ward off inflation, the simple fact that the bank has not raised interest rates, speaks volumes. Despite the rhetoric the ECB is not about to tighten credit any time soon.

Federal Reserve

The last two lines in Federal Reserve Chairman Ben Bernanke's speech Thursday in Washington tell all one needs to know about Fed policy. Financial and economic conditions can change quickly. Consequently the committee remains extremely alert and flexible, prepared to act in a decisive and timely manner and in particular to counter any adverse dynamics that might threaten economic or financial stability. Does that mean a 50 bps cut on January 30th? One would have to say yes, particularly when that statement is combined with the earlier comment, In light of recent changes in the outlook for and the risks to growth, additional policy easing may well be needed. Those two statements are about as close as you can come to a promise from the Chairman. The Fed knows well that this speech will have cemented market expectations for at least a 0.5% rate reduction at month end. Would the chairman and the committee have excited that expectation and then not deliver. Very, very unlikely.

Bank of England

The English central bank left its base rate unchanged at 5.5% on Thursday. Sterling rose 60 points on the announcement but the move dissipated quickly. The second thought being that the MPC will surely cuts rates in February. The MPC did not issue a statement, as is their usual procedure. Several factors lay behind the MPC decision: economic deterioration though notable in some areas of the economy and of concern in others, particularly housing, has not been marked enough in the face of inflation pressures to force the banks hand. The quarterly inflation report is due February 13th and the bank governors often prefer to have the latest inflation data before acting. And finally, market pricing had the decision rated even and perhaps the board members did not want to risk alarming the market with a decision that would likely be interpreted as a danger sign for the economy.