Thursday, April 19, 2007

Inflation, Interest Rates, Exchange Rates and Housing Prices

Financial Times' Chris Giles and Eoin Callan write about the recent rise is the pound due to UK interest rate expectations:

Richard Jeffrey, an economist at Ingenious Media, saw the trend towards rising prices as a return to normality after a period where Britain was more-or-less alone in experiencing sharply falling goods prices on the high street alongside normal levels of overall inflation.

Interest rate expectations jumped and a May rate rise is now considered a certainty. “People have to get used to higher interest rates than we have seen for much of this decade. I am not sure that house-buyers are taking that into account yet,” said Martin Weale of the British National Institute of Economics and Social Research.

Currency traders anticipate higher pound prices as inflation grows giving rise to an expectation for a rise in interest rates, which will draw currency exchanges into the pound.

Matters exacerbate when the U.S. economy slows down but the European economies don't. Inflation rate in the U.S. slows while it speeds in Europe. This forces interest rate expectations in opposing directions in Europe and in the U.S. causing the currency rate swing we have seen recently.

Alan Ruskin, a currency strategist at RBS, said: “What we are seeing is those investors chasing risk moving to higher yielding currencies. These numbers reinforce an existing trend.

“There had been persistent fears about inflation boxing in the Fed and making it difficult to respond to a slowdown in growth. Now the Fed is less boxed in.”

The Fed still views inflation as a slightly greater threat to the US economy than the uncertain outlook for growth but investors sold dollars on the basis that the inflation slowdown made the Fed more likely to keep interest rates on hold and could give the central bank slightly greater flexibility to consider easing monetary policy in future.

US government debt prices rallied as investors priced in a lower likelihood of US rate cuts, sending the yield on the benchmark 10-year note down to 4.71 per cent from 4.74 per cent.

London experienced the opposite trends in bond markets, again contrasting the current accelerating economic expansion in Europe with the slowing US economy.

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