FX Update

Global Finance, Jan 2008 by Woolfolk, Michael

Will Coordinated Monetary Easing Save the Greenback?

The Bank of Canada (BOC) surprised markets on December 4 by cutting rates 25 bps to 4.25%. The bank cited renewed deterioration in the US housing sector and the subprime mortgage market, and the rate cut appeared to be directed at foreign rather than domestic developments. The BOC cut rates despite acknowledging in its accompanying statement that inflation risks remained to the upside.

One explanation is that the 28% rally in the loonie against the greenback during the first 10 months of 2007 risked a fundamental misalignment between the currencies. Cutting interest rates would alleviate some of the downward pressure on USD/CAD. Another explanation is that this represents the beginning of coordinated monetary easing to maintain orderly market conditions and prevent a crisis of confidence in the US dollar.

The US outlook deteriorated in November as financial market turmoil resumed. As a result, market players raised their expectations of further Fed rate cuts in 2008 and the greenback came under renewed selling pressure. With the USD already at record lows against the EUR and CAD, and multi-decade lows against both the GBP and AUD, the greenback was positioned to plunge further if the Fed continued cutting interest rates. The potential crisis of confidence in the USD and resulting disorderly market conditions may have been too great a risk for policy makers. While food and energy prices have risen rapidly this year, headline and core CPI have been remarkably contained. Consequently, Canadian and European officials may be choosing the lesser of two evils by cutting rates and thereby fanning the flames of inflation, rather than face a crisis of confidence in the USD. If interest rate differentials remained unchanged in 2008, the greenback could avoid a speculative attack.

The BOC cut rates with Canadian headline CPI at 2.1% y/y and core CPI at 2.0%. UK headline "harmonized" CPI is currently 2.1% y/y with harmonized core CPI a mere 1.5% y/y. UK M4 money supply is running at 11.8% y/y, the lowest level since May 2006. With inflation levels in Canada and the UK roughly equal, the BOE could cut rates using the same rationale as the BOC. In the Eurozone, harmonized CPI is 3.0% y/y and harmonized core CPI is 1.9%. If Canada can cut rates with core CPI at 2.0% y/y, the ECB can surely cut rates with core CPI at 1.9% y/y. If inflation can remain reasonably contained in 2008, Canada and Europe can counter a crisis of confidence in the USD by pursuing a coordinated campaign of monetary easing. Judging from the loonies reaction to the BOC's change in monetary policy, rate cuts by the BOE and ECB is likely to curb further USD weakness against the EUR and GBP.

By: Michael Woolfolk, Senior Currency Strategist