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Pound Falls On Five Month Low Inflation, Trichet Says "There's a Limit to Interest Rate Cuts"

Tuesday, 16 December 2008 10:10:08 GMT  |  John Rivera, Currency Analyst

Forex traders had sold the pound leading up to the U.K. CPI release sending it to as low as 1.5210. Despite, an initial jump higher after the inflation report showed that price pressures had eased to 4.1% from 4.5% but remained above forecasts of 3.9%, it would eventually trade lower.

Talking Points
• Japanese Yen: Tertiary Index Unexpectedly Rose
• Pound: Inflation Eased Less Than Expected
• Euro: EZ PMI Falls To Record Low
• US Dollar: CPI and FOMC Rate Decision On Tap

Pound Falls On Five Month Low Inflation, Trichet Says “There’s a Limit to Interest Rate Cuts”

Forex traders had sold the pound leading up to the U.K. CPI release sending it to as low as 1.5210. Despite, an initial jump higher after the inflation report showed that price pressures had eased to 4.1% from 4.5% but remained above forecasts of 3.9%, it would eventually trade lower. Additionally, core prices actually rose to 2.0% from 1.9% as decreasing oil prices are failing to filter throughout the rest of the economy. Although prices have fallen to the lowest level in five months it remains 1.0% above the 3.0% target of the central bank and required Governor King to write a letter of explanation to Chancellor Darling.

Despite the uptick in core prices driven by a 1.4% increase in food costs, Governor King in his letter of explanation made it clear that inflation will continue to fall and that in 2009 a letter to explain why the rate has fallen more than 1% below their target may be needed. Indeed, the central bank leader forecasted that prices would drop below 2% by mid 2009 and the possibility exists that they will fall below 1.0%. The committee also sees a sharper fall in 4Q GDP and that the weak outlook will cause considerable slack in the economy. Despite the dovish comments, the sterling has found support at 1.5210 which could lead to a retrace leading up to the Fed rate decision.

The Euro has given back some of its recent gains after the region’s PMI reading showed further contraction in both the manufacturing and service sectors. The Euro-Zone service sector contracted for the seventh consecutive month in December as the advanced PMI reading slipped to 42.0 from 42.5. Additionally, the manufacturing PMI dropped to 34.5 from 35.6, sending the PMI composite to 38.3- its lowest level since recordkeeping began in 1998. A look at the breakdown revealed that new orders declined to 27.4 from 28.8, while the employment component weakened to 39.1 from 41.0. A 0.1% drop in 3Q employment added to the dour outlook for the region’s economy. The labor market is expected to see further weakness as the economy falls deeper into a recession. A look at the country contributions shows that Germany actually saw hiring increase by 0.3%, but given that the country lost 33,000 jobs the past two months we may see a more pronounced drop in the fourth quarter. Despite the weakening economic data, ECB President Trichet made significantly hawkish comments today which may add to the single currency’s recent strength. The central bank leader said that “there’s a limit to interest rate cuts” and that the MPC must beware of being trapped by low interest rates.

The FOMC is expected to cut its benchmark interest rate by 50 bps bring it to a record low of 0.50% which could add to the dollar’s recent weakness. Although the central bank is running out of room with rates at 1.00%, the fragile state of the economy is forcing their hand and leading them toward a zero interest rate policy. Inflation and housing data are due to cross the wires before hand and are expected to strengthen the case for further easing. Consumer prices in November are expected to have dropped 1.3% following a 1.0% decline the month prior. The annualized rate of inflation is expected to sharply fall to 1.5% from 3.7% which would be the lowest since October, 2006. Meanwhile, housing starts are expected to fall to a record low of 706,000 from 791,000 in October. However, if we see prices ease less than expected, it could raise inflation expectations which may lead the central bank to keep rates on hold, which could send the dollar soaring. Yet, a rate hold and a dovish outlook from the MPC following the announcement could spark risk aversion and lead to dollar strength.

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Related Articles:

Euro-Zone Manufacturing and Services Contract for Seven Consecutive Months as Demands Falter
US Dollar Down and Out Ahead of FOMC Decision - What to Expect
U.K. Inflation Falls to Five-Month Low as Dire Outlook for Global Economy

To discuss this report contact John Rivera, Currency Analyst: jrivera@fxcm.com

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