ECB's Only Option is to Be Hawkish (page 1 of 2)

DailyFX Fundamentals 11-06-07

By Kathy Lien, Chief Strategist of DailyFX.com

Australia Raises Interest Rates, Another Reason to Hit Parity

The Reserve Bank of Australia increased interest rates for the second time this year to 6.75 percent. This is the first time ever that the central bank has increased rates when an election is underway. This unprecedented move highlights the degree of inflation pressures the economy faces at the current moment. Comments from the RBA were relatively hawkish; they said that demand and output growth has increased and they expect inflation to top 3 percent by March. They were also surprisingly optimistic about the global economy and indicated that they expect high capacity utilization and worker shortages to persist. In other words, they remain hawkish. Meanwhile the Canadian dollar also hit a fresh record high against the US dollar thanks to a stronger IVEY PMI report. Despite a significantly appreciated currency, manufacturing activity has not slowed materially. Yet this does not mean that the Bank of Canada is not worried. Senior Deputy Governor Jenkins said today that should the Canadian dollar remain at current levels, it would pose significant downside risks to growth. When asked if intervention could be possible, instead of denying it, he said that in order for intervention to be effective, it would have to be followed up by other policy actions. For the time being, we do not think intervention is likely, but if the US economy slows significantly and the loonie remains below parity, the Bank of Canada may seriously consider that possibility. As for the New Zealand, it has benefitted from the overall rise in commodity prices. Third quarter unemployment is due for release tonight and the numbers are expected to continue to reflect a tight labor market.

ECB's Only Option is to Be Hawkish

The Euro is slowly inching towards the psychologically important 1.50 level. Today the single currency made a new record high on the back of broad dollar weakness and stronger inflation and service sector data. We are less than 48 hours away from the ECB's interest rate decision and even though no one expects rates to be increased, everyone does expect ECB President Trichet to become increasingly hawkish. Today's economic data provides further evidence of why hawkish policy is his only option. With producer and consumer prices both continuing to climb, inflation is a persistent problem. Oil prices were up another $2.70 today which will only exacerbate inflation in the months to come and the ECB is fully aware of that. Having been so proactive with injecting liquidity in the midst of the credit crunch in August, the ECB may choose to be proactive again with combating inflation. They need a strong Euro to offset the rising the cost of oil which is why we haven't heard one word of complaint from Trichet even though the Euro has risen above 1.45. Also, the latest service sector PMI data indicates that the impact of the strong Euro on the overall economy is still limited. However not all news was good news; Eurozone retail sales were softer than expected. As long as spending is increasing and not decreasing, we are not worried.

US Dollar Continues to Weaken as Banking Sector Turmoil Raises Rate Cut Expectations

The US dollar is weaker across the board despite the lack of any US economic data. The rally in stocks and move in the US dollar suggests that a growing number of traders believe the Federal Reserve will bail out the banking sector with another interest rate cut.