Foreign Currency Report 18 April 2007

UK inflation hit a record high in March, helping the pound crack the 2 dollar level for the first time since 1992 and cementing expectations of a Bank of England rate hike next month.

Official figures yesterday morning unexpectedly showed the key annual CPI rate which the BoE is charged with targeting at 2.0% surging to 3.1% in March.

This news all but cements market expectations that the BoE will increase interest rates at its meeting next month and raises questions over whether domestic inflationary pressures are building within the economy which will necessitate further hikes beyond that.

UK short sterling futures a gauge of interest rate expectations fell sharply after the CPI announcement, with market players now pricing in a cumulative rise of 0.50 points by the end of the year.

'Inflation risks are out of control and the BoE must respond with another rate hike at the next MPC meeting in May,' said David Brown at Bear Stearns, adding that rate-setters may even opt for a half rather than a quarter point rise next month.

'Inflation should come down later in the year, but this short term acceleration will test the Bank's nerves in the next few months,' he said. Bank of England governor Mervyn King also focused on the short-term nature of the inflation figures.

'The Committee will continue to look through the short-term volatility in inflation over the next year or so resulting from fluctuations in domestic energy prices and set Bank rates to keep inflation on track to meet the 2.0 pct target in the medium term,' he said in an open letter to Chancellor Gordon Brown. King blamed a spike in oil, food and furniture prices for the rise, and said part of the increase can be attributed to base effects.

'As the substantial increases in household gas and electricity prices that occurred a year ago drop out of the annual comparison, and the falls in those prices which have already been announced take effect, CPI inflation is likely to fall back within months,' he said.

The rise in inflation will be a major concern for homeowners due to the impact on the Bank of England's interest rate policy.

'People have to get used to higher interest rates than we have seen for much of this decade,' said Martin Weale, director of the National Institute for Economic and Social Research.

The pound broke the 2-usd level shortly after the news broke, and went on to consolidate its strength after US inflation data came in weak, adding to speculation the Federal Reserve will cut interest rates later this year.

In other news.
The Australian dollar opened at its highest level in more than a decade this morning, surpassing the heights it reached yesterday, as the US currency weakened.

The Australian dollar's strength was a product of US dollar weakness, ICAP chief economist Michael Thomas said.

"There was quite a bit of weakness across the board for the US dollar," he said.
"It's not just the Aussie that's gained.
"There was lots of movement in lots of currencies."
The Australian dollar has gained in recent days as speculation of an interest rate rise has mounted. The Reserve Bank of Australia's (RBA) assistant governor, economics, Malcolm Edey, has said that the underlying inflation rate of 2.75 per cent was too high rather than too low, again suggesting a rate rise could be on the cards next month.