LONDON, 19 May 2003 — Last week the US and the European Central Bank both left the respective key interest rate unchanged. The Fed funds rate continues to be at the extremely low level of 1.25 percent and the repo rate continues to be at 2.5 percent.
After the Fed had felt unable to give any outlook on the economy and inflation after the Federal Open Market Committee (FOMC) March’s meeting due to the Iraq war, the Fed set the bias on weakness after the May 6 meeting. This is the first time the Fed put the bias on weakness since the interest rate has been lowered to 1.25 percent in November last year. The Fed cited that “an unwelcome substantial fall in inflation” might threaten growth in the US economy.
However, we do not share the concern of a sharp decline in inflation. The core consumer price inflation (excluding energy and food) is currently at a 1.7 percent annual rate. It is true, that the fall in energy prices (the annual CPI energy price inflation in March was at 23 percent) will bring down the headline CPI inflation considerably. But the headline inflation is at a high 3 percent and the depreciation of the US dollar will lead to higher import prices. Lower energy prices will also be a boost for (non energy) consumption and will reduce costs for companies, so it will support the recovery of the US economy. We do not believe that the Fed will decrease rates (the next FOMC meeting is on June 25), when inflation falls and the economy shows signs of recovery.
The ECB in its press conference after the rate decision on May 8 stressed that they expect inflation to come down further in the intermediate term. They cited lower oil prices, moderate economic growth, stabilizing labor costs and the higher external value of the euro as reasons for the expected decline in inflation. We are quite confident that the ECB will reduce rates further on its meeting in June. Compared to the US Fed fund rate, the ECB repo rate is higher, and the call for a decline in inflation is supported by a stronger currency.
The March deficit in the US trade balance amounted to $43.5 billion, which is close to the all-time high in the trade deficit in December last year. Remember that the current account deficit reached 5.2 percent of gross domestic product (GDP) in the fourth quarter of last year, an all-time high, and the national accounts data for the first quarter suggest no improvement in the first quarter of this year. The high trade deficit resulted from soaring goods imports (+3.5 percent mom, +15 percent yoy), but exports were also quite dynamic (+1.5 percent mom, +5.6 percent yoy). The increasing trade deficit together with the high interest differential may be seen as reasons for the fall of the US dollar.
In the Euro Zone, the sentiment index resulting from the Center of European Economic Research (ZEW) improved considerably in May from 29.5 percent to 35.5. The level of this business index suggests that euro zone industrial production should increase by around 2 percent. This is the first euro zone business sentiment index since the end of the Iraq war that recovered, but it is also the first index published for May. The same index for Germany, which normally develops quite similar to the euro zone index had a much slower recovery and is at a much lower level. Whereas the gap between the two series seemed to close in the previous months, it opened again and stresses that Germany’s growth will continue to be much weaker than the euro zone average.
We have not yet seen a broad based recovery of the economic indicators as we had expected as a result of the end of the Iraq war. Whereas consumer confidence recovered in the US, in the euro zone and in Japan, the only business survey that started a recovery is the ZEW economic sentiment index for the euro zone. Concerning a change in our investment strategy, similar to the central banks, we also follow a wait and see policy, which means that we continue to be neutral on equities. In a long-term perspective, however, we think that with the recent cost savings initiatives (resulting in higher earnings despite of disappointing sales) companies are well prepared to boost their profits in an eventual economic upswing. So in the coming weeks, we will watch for triggers to increase our equity exposure.
(The information contained herein is for information only and should not be construed as an offer or a solicitation to purchase, subscribe, sell or redeem any investments. While Clariden Bank uses reasonable efforts to obtain information from sources, which it believes to be reliable, Clariden Bank makes no representation or warranty as to the accuracy, reliability or completeness of the information)
