USD weakness has created an inflationary impulse to the global economy. USD pegged currency system works as an inflation multiplier. The Fed has noticed this risk and is willing to act, but the ECB is working from a different agenda. Effectively, the Fed and the ECB are running diametrically opposed policy approaches which will potentially cause capital markets to riot. The Fed will have very little option than to let its words be followed by action. Currency intervention might soon be on the agenda.

Inflation and related policy responses drive currencies Inflation has become a global theme and the currency market reaction depends on how central banks deal with the threat of inflation. There are cases of denial with some countries, even halting the release of inflation statistics (UAE), while other central banks are vigorously increasing interest rates and tightening monetary conditions (ECB, SNB and RBA). Related currencies have been flying and in all cases have reached overvalued levels when measured in purchasing power terms. While tighter monetary policy is aimed at creating cyclical deflationary forces to take inflation back to desired levels, it may be dangerous to just look at national targets when fighting inflation, especially for central banks with global weight, such as the ECB, who have to take into consideration how their policy works within a global context.

USD currency pegs work as an inflation multiplier About 65 countries have their currencies pegged to, or run a dirty float with, the USD. Very often the USD is the dominant currency within currency baskets of countries running a currency basket pegged system. China, now the world’s 4th largest economy after the US, Japan and Germany, still regards the USD as its main reference currency. Hence, the value of the USD impacts China’s economic outlook and especially inflation. The IMF has pointed out that the recent commodity price increases can be explained by the USD fluctuation, especially true of oil and gold. A declining USD very often sees oil prices increasing – even on those days when the decline of the USD is caused by weak US data releases. Normally, weak US data should suggest lower US oil demand down the road and thus lower oil prices, but the energy market has become mechanical, trading on the back of the USD.

USD weakness has become counter productive Recognising this effect and witnessing its import prices rising by 15% yoy, US authorities have started talking the USD up. But, the weak USD is not only inflationary for the US via increasing import prices, especially for those products where price behaviour is negatively correlated with the USD such as oil, it also increases inflationary pressure in USD pegged countries. While the relative importance of the US economy has declined it still comprises 30% of total global demand. Add to that the economic weight of countries pegged to the USD such as China, and we see 40% of global demand influenced by the value of the USD. A weak USD has driven commodity prices up. The commodity market has become increasingly driven by financial flows, with this market benefiting from an USD220bln inflow of capital in the year 2007 seeking financially motivated investments. The result is a speculatively run market place where investors look for correlations instead of demand and supply analysis on which to base investment decisions. At least in the short term, a higher USD would reduce commodity prices as financially motivated commodity long positions would be squeezed, providing 40% of the globe with some breathing space when it comes to inflation.

Breathing space required This breathing space is urgently required. Globally housing markets have rolled over and the last thing this market place could cope with right now is rising funding costs, especially in the US where the interdependence between the housing and financial market is most emphasised. However, rising inflation combined with decreasing economic activity will destroy asset values and with global investors owning more than 20% of the US’s total assets a stagflationary economy would be disastrous in the case of foreign investors throwing in the towel and running back to home currencies. The USD would collapse (releasing even more inflationary pressure) and the US yield curve would steepen. US authorities seem to have recognised this problem by trying to stabilise the USD.

The US is looking for Allies too support the USD There have been suggestions that the US has agreed with GCC and some Asian countries – all of which are certainly financially potent - to buy up the USD. If this policy would have been successful, the USD would have risen, commodity prices would have come down from their speculative highs, easing global inflation pressure. Unfortunately, things have turned out differently with commodity prices at historic highs and the USD back under pressure.

ECB torpedoes Fed ECB runs an inflation target driven policy and ECB President Trichet admitted that in this respect the ECB’s job was easy. However, it is not the first time that a mono-targeted central bank policy approach as led to high market volatility. Just remember 1987 and 1992 when the tight monetary policy of the Bundesbank created market turbulence. European inflation has shot up to 3.6% and in August / September the headline inflation rate will be around 4%. But, core inflation has remained well behaved and while we would not deny the risk of developing second round effects in core European countries such as Germany, the bargaining position of labour unions in peripheral Europe is weak. Of course, central banks must have the right to tighten monetary policy if required, but the ECB’s more or less clear announcement suggesting it will hike rates in July has hit an economy already turning down. Even the relatively strong German economy has reported five consecutive declines in manufacturing orders. The last time Germany’s manufacturing sector experienced such weak order readings was in 1992 when its unification boom turned to bust. While a central bank tightening conditions when the economy is in a downturn is bad enough for the domestic economy, the impact of the announced tightening on the global economy has the potential to be disastrous.

Central banks should co-operate Central banks are expected to cooperate and markets are sensitive to any sign of lagging cooperation or diametrical policy approaches. The Fed’s suggestion to lift the value of the USD to ease the price pressure in the US and those countries operating currencies pegged or quasi pegged to the USD makes sense given the USD’s foreign value importance to the price direction of commodity markets. The ECB has torpedoed the USD’s attempt to rally by announcing that it seeks tighter monetary conditions. While the combination of a lower USD and higher commodity prices will drive US inflation higher once again, it might be Asian economies that get a massive hit. Asian inflation has accelerated sharply driven by higher food prices. Domestic energy prices have been subsidised and thus rising energy costs have not fully shown up in inflation rates, but have led to a sharp deterioration of fiscal and current account balances. Countries that need to import capital are no longer seeing sufficient capital inflows. Local capital markets have sold–off hard and currencies have come under pressure. India, Philippines and Indonesia fall into this category and it is here were the growth outlook weakens most. A stable USD and lower oil price would have eased some of the selling pressure, but instead a lower USD and higher commodity prices is seeing some EMK countries starting to wobble. If the ECB would have held its rate outlook unchanged the global economy would face less risks.

ECB increases first round inflation However, even the ECB might lose out when commodity price increases lift first round price pressure in the eurozone. Nothing is gained in respect of first round effects when import prices in USD terms rise as much as the EUR, but what has been seen over the past week is that USD factored commodity prices rose at a faster pace than the Euro, thus increasing headline inflation pressure in the months to come. The first round inflation hurdle has become higher and the irony of this development is that it was started by Trichet’s announcement to hike rates in July. To respond to higher commodity prices with tighter monetary conditions while the economy is weakening must undermine asset markets and will lead to increasing volatility. Nonetheless, the risk of falling asset prices is the biggest in the US and Asia. In the US, foreign accounts might lose interest in holding assets within a stagflating economy, while in the case of Asia soaring inflation will undermine domestic demand conditions. Hence, it will be the USD and selected Asian currencies, such as the INR, PHP and IDR that stay under pressure. In general we see all EMK currencies that depend on capital imports and where these capital imports have been mainly generated by portfolio inflows, coming under pressure. The TRY and ZAR fall into this category.

Central bank test will lead to intervention Markets have a history of testing central banks especially when there is an obvious policy inconsistency, as we believe is currently developing between the Fed and ECB. The Fed has been very explicit when talking the USD up and it must be assumed that the Fed has co-ordinated its USD stance with the Treasury. The Fed would loose credibility if it would not follow up its reference of a higher USD with further verbal intervention (Bernanke will speak again on Tuesday) and if that does not work the bank will have to follow up with additional action. Rate hikes are out of the question given the state of the US housing market, which is interest rate sensitive. Intervention will be the only policy tool and we think the Fed will have little other choice than to use it.

The information published in this document has been obtained from public sources believed to be reliable. BNP Paribas does not make any representation or warranty, express or implied, in connection with the accuracy of the opinions or statements contained herein. The information provided by this document is only indicative, not to be relied upon as substitution for the exercise of judgment by any recipient, and subject to change without notice. BNP Paribas shall not accept any liability whatsoever for any direct or consequential loss arising from any use of material contained in this document. This document is not intended as, and does not constitute, an offer or a solicitation to buy or sell any instrument or to enter into any transaction. Any reference to past performance should not be taken as an indication of future performance. This document should not be reproduced (in whole or in part) without BNP Paribas’ written consent.  © BNP Paribas (2008). All rights reserved.