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If the credit markets remain tight and economic growth in the US has slowed dramatically, why wouldn’t the Federal Reserve continue slashing rates at their next meeting on April 30? One word: inflation. Inflation concerns have come to the forefront as FOMC voting members Charles Plosser and Richard Fisher have dissented in the past in favor of “less aggressive” policy, and recent commentary suggests they will do the same going forward.

Yield Spread Analysis 04/15 – 04/22

As equity markets around the world have recouped significant losses, government bonds have generally fallen and led yields higher. The biggest shift was seen in the UK and in Europe following the BBA’s announcement that a review of the system that sets Libor rates that was initially planned for June is now “currently under way” amidst increasing questions about its reliability and speculation that banks were underreporting the rates they pay to borrow. Indeed, a day after the announcement, Libor rates jumped to the highest levels since March 13, indicating that banks were rushing to report their borrowing costs more accurately. As a result, the UK yield curve inverted sharply as short-term rates have surged over 50bp since then. In the Euro-zone, the jump in short-term rates was matched by gains in 10-year bonds on hawkish commentary by ECB officials.

Looking ahead, Australian Consumer Prices, the release of the BOE meeting minutes, and US Durable Goods Orders offer the most significant event risk for Australian, UK, and US government bonds. However, the primary driver of fixed income and equity markets remains risk appetite, and a marked return to risk aversion could lead yields to tumble rapidly as traders sell off stocks and carry trades in general.

For a full schedule of upcoming event risk, see the DailyFX Calendar.

US Fed: Why They Will Not Cut More Than 25bps Next Week

If the credit markets remain tight and economic growth in the US has slowed dramatically, why wouldn’t the Federal Reserve continue slashing rates at their next meeting on April 30? One word: inflation. Inflation concerns have come to the forefront as FOMC voting members Charles Plosser and Richard Fisher have dissented in the past in favor of “less aggressive” policy, and recent commentary suggests they will do the same going forward. Indeed, other FOMC members are hopping on board the hawk train, as alternate voting member Richard Lacker went so far as to call it a “problem.” With commodity prices, including oil, rice, and wheat, rocketing to record highs, it’s no surprise that recent CPI data reflected building price pressures in the US. As a result, the FOMC is highly unlikely to enact anything more than a 25bp cut next week, and some members may even dissent in favor of no change.

Charles Plosser, Federal Reserve Bank of Philadelphia President (Voting Member)

		“Not only is this not true, it is a dangerous misconception and runs the risk of setting up expectations that monetary policy can achieve objectives it cannot attain. To ensure the credibility of monetary policy, we should never ask monetary policy to do more than it can do.” – April 18, 2008
		“…the bottom line is that, on the monetary policy front, the Fed’s response to the deterioration of the economic outlook and the turmoil in financial markets has resulted in an accommodative level of real interest rates that should support the market forces that will bring economic growth back toward its long-term trend.” – April 18, 2008

Richard Fisher, Federal Reserve Bank of Dallas President (Voting Member)

		"I have maintained a strong reluctance to further general monetary accommodation. The answer...is not to compound the bad by repeating the oft-prescribed remedy of inflating our way out of our predicament with a wing-and-a-prayer promise that it can always be reined in later." – April 17, 2008

Frederic Mishkin, Federal Reserve Board Governor (Voting Member)

		“The health of the US economy depends importantly on the vitality of the small business sector, and continued access to credit on competitive terms is necessary for that vitality.” – April 17, 2008

Janet Yellen, Federal Reserve Bank of San Francisco President (Alternate Voting Member)

		“Until recently, the deflating housing bubble had not spilled over to the rest of the economy. But now it has. It seems likely that this sector will be a major drag on the overall economy through the end of this year and into 2009.” – April 17, 2008

Jeffrey Lacker, Federal Reserve Bank of Richmond President (Alternate Voting Member)

		"Inflation is a problem now. It is too high and personally I would be uncomfortable in just waiting for economic slack to bring it down." – April 17, 2008

ECB: Will Trichet’s Inflation Focus Ultimately Help or Hurt Europe?

In case you haven’t heard, the European Central Bank remains extremely hawkish. ECB President Trichet almost always holds this bias, but lately, many other European central bankers have come out of the woodwork issuing inflation-focused comments. For the most part, the ECB has taken an extremely different path from the Federal Reserve, as they’ve chosen to stick to their primary mandate of price stability. So who has done the right thing: Trichet or Bernanke? Only time will tell, but with European banks issuing Q1 earnings over the next few weeks, we may get our answer sooner rather than later.

Lucas Papademos, European Central Bank Vice-President

		“There is a risk that the current temporarily high annual inflation rates, which may persist for a rather protracted period of time, could have second-round effects on wage and price setting.” – April 22, 2008

Yves Mersch, European Central Bank Governing Council Member

		“At the moment, it is more likely that in June we have to adjust upward our inflation projections.” – April 22, 2008

Erkki Liikanen, European Central Bank Governing Council Member

		“Inflation risks are real. Our prime mandate is price stability. And history shows that if you fail there, it's a long negative impact on growth and it's very hard to get back.” – April 21, 2008

Axel Weber, European Central Bank Governing Council Member

		“This is a very unsettling environment for a central bank orientated towards stability. Should further price risks or second round effects occur, we need to act with determination.” – April 18, 2008
		“Current medium and longer term market interest rates are still anchored at levels consistent with the ECB's price stability.” – April 17, 2008

Nicholas Garganas, European Central Bank Governing Council Member

		“The short-term outlook for inflation isn't satisfactory. Inflation is likely to remain at elevated levels for the coming months and is likely to moderate to the 2 percent level only very gradually. The balance of risks to the short-term global outlook remains tilted toward the downside. Meanwhile, inflation remains strong mainly because of oil and food prices. In this environment, the greatest contribution that central banks can make is the firm anchoring of medium- to long-term inflation expectations.” – April 16, 2008