Foreign Currency Report 10 April 2007

GBP
For the third month running, the Bank's monetary policy committee held rates at 5.25%, a decision greeted with relief by retailers, estate agents and small businesses. But the UK's leading employers' groups, the CBI, the EEF, the British Chambers of Commerce and the Institute of Directors, said there was a strong possibility of a quarter-point rise next month after the Bank of England has completed its quarterly health check of the economy. Sterling dipped slightly on the foreign exchanges after the MPC decided against a fourth increase in lending costs since August 2006, but the pound's falls were limited by the feeling it was just a question of time before the MPC moved again. "There are signs of renewed vigour in the economy, with continued growth in consumer spending," said Richard Lambert, director-general of the CBI, "which means that a rate rise is not out of the question next month." Roger Bootle, economic adviser to Deloitte, said: "Thursday's decision by the MPC to leave interest rates unchanged at 5.25% is a short stay of execution as it is extremely likely that interest rates will be raised to 5.5% next month. And interest rates may have to rise further thereafter." Since the last MPC meeting, the annual inflation rate rose from 2.7% to 2.8%, taking it further from Gordon Brown's 2% target. Although the Bank believes inflation will drop back during 2007 as last year's hefty increases in energy bills are not repeated, a sizeable minority of City analysts had been expecting a rate rise. They cited evidence that firms were passing on higher costs to their customers and the strength of the housing market as reasons for the "hawks" on the MPC to press for dearer borrowing. There was speculation on Thursday night the minutes of the MPC meeting, due out in a fortnight, will reveal a knife-edge vote in favour of no change. Adam Lent, the TUC's head of economics and social affairs, said: "A rise in rates is almost certainly on the cards, but the MPC was right not to act before studying the Bank of England's own inflation report, due out next month. With UK manufacturing looking a little shaky and housing pressures easing slightly, waiting a month was the most sensible option." Figures from the Office for National Statistics showed output from Britain's factories fell by 0.6% in February. Back-to-back cuts in production in the first two months of 2007 meant the first quarterly drop in output since the end of 2005. This was seen by analysts as evidence that higher interest rates and the strong pound were starting to have an impact.

USD
The dollar rose broadly on Friday, hitting a fresh five-week high against the yen, as a surprisingly strong U.S. jobs report reinforced the view the Federal Reserve will not cut interest rates in the near term. The robust March jobs report eased concerns about the weakening U.S. housing market and signs of softness in U.S. manufacturing. "This could well be the strongest economic report we've had out in the first quarter," said Michael Woolfolk, senior currency strategist at Bank of New York. "It suggests that the U.S. economy is on a firmer ground than earlier thought and the Fed need not cut interest rates under the current circumstances," he added. Economists said the numbers boosted the odds of moderate, consumer-driven economic growth and lowers the chances of any near-term reduction in official interest rates. The recent fall in the US housing market and defaults in mortage lending had sparked expectations that rates would have to be cut. Peter Morici, professor at the American Robert H. Smith School of Business, said that the strong employment growth indicates the economy continues to expand, despite the drop in new housing construction, slower productivity growth and tepid retail sales. He said the consensus forecast for first quarter Gross domestic product growth is 2.3 percent, and that Friday's employment numbers are consistent with that estimate. GDP grew 2.5% during the fourth quarter, and recent data including weak housing and business investment suggest growth could be below 2% in the first quarter. The US Labor Department said that in March, non-farm payrolls increased 180,000 compared with a Wall Street's expectation of a 142,000 rise. Figures for January and February were also revised up. Economists also expected a 4.6% unemployment rate and 0.3% rise in wages. The formal figures for March put unemployment at 4.4 per cent, among the lowest since 2001. However, with the jobless rate at six-year lows and wages on the rise, consumers should remain well supported in coming months. Consumer spending makes up about two-thirds of GDP, so even modest growth there can offset sizable drags in other sectors. The jobs data also support recent remarks by Federal Reserve Chairman Ben Bernanke indicating that he expects "moderate" economic growth due to "solid" consumer spending. The Fed is widely expected to hold interest rates steady at 5.25% for a seventh-straight month when it meets in May. Though the Fed recently dropped its explicit reference to the possibility of higher rates, Mr. Bernanke said last week "we have not shifted away from an inflation bias."