From the April 01, 2011 issue of Futures Magazine • Subscribe!

Currencies: Balancing inflation and world events

The Federal Reserve is taking a very different approach to monetary policy. While the February employment report showed unemployment dropped to 8.9%, there has been very little talk about ending QE2 early, much less raising interest rates (see "No change in sight").

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The big distinction is the role of unemployment. The ECB enjoys a much simpler role in that it exists mainly to encourage price stability. "The primary objective of the ECB’s monetary policy is to maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term," the ECB website says. The Federal Reserve has a more involved mission that has evolved over time and now includes a mandate to pursue full employment.

"Bernanke’s constant reference point for the health of the economy seems to be the labor market," Wilkinson says. "No matter how much business confidence revives or how much manufacturing activity resumes, it’s all redundant to him until we see meaningful gains in employment."

As a result of the difference, the two central banks are pursuing very different monetary policies and will have very different impact on their currencies. "It shows that one part of the world is dealing with growing inflationary pressures whereas the Federal Reserve, because of the high level of unemployment and the high abundance of spare capacity, doesn’t see inflation as a problem," Lien says. "Everyone is realizing the Federal Reserve will be trailing other central banks and will be behind the curve."

Euro struggles

Trichet and the ECB have made it clear that inflation is their biggest concern and have indicated a readiness to raise interest rates to combat it. Sovereign debt problems may resurface as a result and dampen potential gains in the euro. "Sovereign debt problems are going to keep a lid on an explosion in the euro," says Darin Newsom, senior analyst at Telvent DTN. "It seems like every time we start to show these signs that the euro is undervalued, these things are tending to pop up again."

Lien sees economic data being a more likely indicator for the euro. "The latest sentiment indicators still show businesses and consumers are relatively optimistic. That provides enough of a backdrop for the ECB to tighten monetary policy and that should be positive for the euro."

Lien warns there could be downward pressure on the euro if a number of banks fail the stress test, though.

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