The ECB rate differential: European rates are at 4.0%, the ECB has a neutral bias with strong anti-inflation rhetoric; the Fed is at 3.0%, with an easing bias and little rhetorical support for the Usd or against inflation. The Fed will cut again March 18th by at least 50 basis points and while this is priced into the market Federal Reserve Chairman Ben Bernanke has not yet signaled a possible end to reductions. His recent Congressional testimony seemed to favor a declining dollar for the prop it provides US export industries. Rhetorical backing for the dollar from Treasury Secretary Paulson and even President Bush has been discounted on the sensible observation that the official strong dollar policy seems to be a policy of watching the dollar decline while claiming the US has a strong dollar policy albeit one set by market forces. The Europeans have been far more active in criticizing the excessive movements of the currency markets, i.e. the strong euro. An ECB rate cut, which a little more than a month ago was considered imminent, has now moved off far into the fall. The balance of interest rate policy has shifted decisively back into the euroâ€™s favor.
The European Monetary Union (the EMU consists of the 15 countries using the euro) has a much stronger economy than the United States. EMU fourth quarter GDP was +2.2% annualized, in the US Q4 was +0.6%. Looking ahead to 2008 (1st quarter advanced GDP figures for the US will be reported April 30th) the US is expected to be flat or negative; EMU growth is forecast to be up 1.5%-2.0%. Economic advantage to the euro.
EMU economies have proven more resilient to the American slowdown than anticipated. The German ZEW survey of financial experts is one of the most closely followed German indicators, its â€˜economic expectationsâ€™ category rose in March for the second month in a row. February had been the first gain in 9 months. The US slowdown is having less effect on EMU economies than forecast. Is there partial decoupling? It is always possible that as the slowdown in the US grinds on it will take its toll on European industry, that is still the general expectation, but as yet there are few signs of this impact in Europe. EMU Industrial production expanded in January for the first time in nine months, adding 0.9% for the month, a 3.8% improvement over the elapsed year. Economic resilience to the euro.
The financial and credit crisis is primarily a US problem. It keeps returning like the undead in an old horror movie, this week haunting Bear Stearns an investment bank heavily involved with the collapsed mortgage market. Until the markets--equities and currencies--have comfort that the credit and liquidity problems are over a strong recovery in the US economy or the dollar is unlikely. The strong rise in the dollar after the Fed announced its new liquidity programs was an unusual currency reaction to what was basically a credit market fund injection but it gives a sense of the lurking forces for dollar strength if and when the US credit crisis is resolved. Temporary credit advantage to the euro.
First and foremost the Fed rate cuts will result in stronger US economic growth in Q3 and Q4. 225 basis points (2.25%) in reductions are already working and at least 50 points (0.50%) more are coming on March 18th. Don't buck the Fed is an old market saw. Rate cuts of this scale and speed will produce a positive GDP response; they always have in the past. Six to twelve months is the normal delay before results begin to show and the current cycle is already six months old; it began last September 18th . A stronger economy will let the Fed return its attention to inflation.
The EMU economies are unlikely to remain immune to changes on this side of the Atlantic forever. The GDP growth cushion is less in Europe. In the US GDP fell more than 4.0% from the 3rd to the 4th quarter; in Europe a fall of less than half that amount brings them to recession.
American inflation is rising. A 2.3% core CPI rate may give the Fed policy cover but it masks a world of trouble. The core concept excludes the supposedly volatile sectors of food and energy. But the sky high oil price is largely demand driven. You would be hard pressed to find an oil analyst who expects prices to return to $50. Oil prices above $75 will be a permanent factor in the US inflation picture and the headline and the core rates will be driven higher. The Fed must target inflation again the question is when. The answer is probably as soon as it feels the economy can withstand the pressure
The Euro is overextended. Since August 2007 it has risen more than 15% against the dollar, since its most recent low in early February it is 7.5% higher. Currencies do not move unilaterally, profits will be taken. Traders await a trigger.
With all that said the negative dollar trend cannot reverse until the basic economic and interest rate facts have changed. A modern economy runs on credit. The paramount impediment to a economic recovery in United States and in the dollar is the combined credit and liquidity crises in America. Mr. Bernanke has judged, and rightly I think, that the credit system is the crux of the matter. To borrow from Frank Herbert, â€˜the credit must flowâ€™. Until that happens all dollar bets are off.