Sunday, November 22, 2009

FX Briefing : Bernanke Sees Headwinds for US Recovery

  • Bernanke: Fed's commitment to price stability supports strong dollar
  • US interest rates set to remain exceptionally low until beginning of 2012?
  • US data confirm doubts about strength of economic recovery
  • Bundesbank signals gradual unwinding of unconventional measures

EUR-USD was over 1.49 for most of the week, despite the fact that the majority of US indicators turned out weaker than expected, which, according to the pattern of the last few weeks, should in fact have had a dampening impact. In addition, Fed president Ben Bernanke revealed that he was relatively sceptical about the US recovery, thus confirming that the US central bank would maintain its accommodative monetary policy stance for a long time to come. At first, as in the two previous weeks, the euro was buoyed by rising equity markets. But then they plummeted in the second half of the week on mounting risk aversion. Subsequently, the dollar and the yen strengthened against the euro. At Friday's fixing, EUR-USD was back around last Friday's level again at 1.4863.

On Monday, the dollar received temporary support from Mr Bernanke's speech at the Economic Club of New York. Fed representatives rarely comment on the dollar, as the Treasury is responsible for exchange rate policy. But this time, Mr Bernanke said that the dollar, as a particularly liquid currency, had strengthened during the financial crisis. As financial market functioning had begun to improve and economic activity had picked up, the dollar had accordingly retraced its gains. Exchange rate development was one of the factors which affected the inflation outlook, and the central bank's commitment to price stability, “together with the underlying strengths of the US economy, would help ensure that the dollar was strong and a source of global financial stability.”

Otherwise, Mr Bernanke focused on the economic outlook. He named factors that could constrain the pace of economic recovery: on the one hand, banks were reluctant to lend. Although lending was expected to normalise as economic conditions improved, the fallout for banks from commercial real estate could slow that progress. On the other hand, the unemployment rate, currently over 10%, was likely to decline only slowly. Given the weak job market and subdued wage growth, households remained cautious about spending. For these reasons, and given low rates of resource utilisation, inflation was likely to remain subdued, which warranted keeping the federal funds rate at an exceptionally low level for an extended period.

Markets thought remarks made by James Bullard, president of the St Louis Fed, gave some indication as to how long this “extended period” could be. Mr Bullard said that the Fed had not begun to raise interest rates until 2½ - 3 years after the end of past recessions. Applied to the current situation, this would mean that interest rates would not be raised until the beginning of 2012. Subsequently, the dollar weakened significantly. However, Mr Bullard also remarked that markets could regard this as “too low for too long” - particularly as very low interest rates are thought to have contributed to the housing market bubble. Finally, Mr Bullard appealed to the markets not to concentrate so much on interest rate policy. The Fed's decisions had recently focused on quantitative easing measures. How to adjust these measures to the current situation was the main challenge.

Comments made by other central bank representatives also indicate that US monetary policy will focus on warding off economic risks for some time to come. Janet Yellen, president of the San Francisco Fed, for instance, raised the question of “whether monetary policy should seek to lean against potentially dangerous swings in asset prices” by raising interest rates. The ensuing macroeconomic slowdown could be costly. More stringent capital requirements would be a better option to stabilise the financial system. Neither Mrs Yellen nor Mr Bernanke nor vice-president Donald Kohn see a danger of price bubbles on equity markets forming at the moment.

The US indicators confirmed the central bankers' cautious economic and inflation assessment: producer prices fell by 0.6% month-on-month, and industrial production only rose marginally. Housing starts and building permits in particular fell short of expectations, declining markedly. The 3-month growth rate of housing starts, which had reached an impressive +23.8% in July, posted a decline of 10.8% in October. Residential construction investment, which soared in Q3 by over 20% annualised, after having fallen for 14 consecutive quarters, thus appears to be in for a setback again in Q4.

Whereas a monetary policy shift appears to be a long way off in the US, the Bundesbank's November Monthly Report was quite optimistic, stating that, in view of the more favourable financial market situation and improved refinancing conditions for banks, the question of gradually unwinding unconventional measures was becoming more acute.

If these words are intended to prepare markets for the ECB governing council meeting in December, it looks as though the eurozone is likely to implement a monetary policy turnaround sooner than the USA. This will probably strengthen the euro. Moreover, the single currency could be given a boost next week if the euro area sentiment indicators for November continue their moderate upward trend, as forecast.

This report has been prepared by BHF-BANK Aktiengesellschaft on behalf of itself and its affiliated companies (together "BHFBANK Group") solely for the information of its clients.
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