Mark O'Sullivan sees the sterling/euro pair as one to watch, and testing times ahead for central bankers and the Bank of England
There's no doubt that the good economic times of the 'Goldilocks scenario' - measured by low unemployment, low interest rates, low inflation and strong growth - are well and truly over, and indeed there are some very dark clouds on the horizon.
In the UK, the BoE has been reeling from a round of punches that began with the Northern Rock crisis and led to inflation moving above 3% (forcing Mervyn King to write to the Treasury to explain this), and has since been aggravated by a slowing housing market and the threat of stagflation, as wage increases fuelled by higher energy costs push inflation even higher and threaten to force the BoE to take drastic action by raising interest rates.
Interestingly, Governor King wrote a paper outlining this threat to the UK economy - slowing growth and sharply rising inflation - and his cure was to initiate sharp rate hikes followed by rate cuts to 'snuff out' inflation, although the pain would have to be passed on to the consumer. However, now that we have reached this situation, he seems to be backtracking, and looking for the price of energy to retreat to bring inflation back into line. But with oil trading comfortably above $120 per bbl, this could prove wishful thinking.
The BoE's outlook is for rates to remain on hold, opening the door to potential cuts in late 2008; however, you cannot rule out a hike if inflation fails to retrace. This indecision, and the currency markets' belief that the worst is yet to come, will see sterling remain pressured and at multi-year lows against a basket of currencies.
The interesting currency pair to watch could be the sterling/euro one, as perhaps the doomsayers who have been calling for parity could be proved wrong. It seems that a move above EUR1.30 could develop as the outlook in mainland Europe deteriorates and selling pressure mounts on the euro.
Alan Greenspan once said it is the job of a central banker "to take away the punchbowl as soon as the party gets started". You need look no further than New Zealand to find that the punchbowl has gone and the lights have gone out. After enjoying 10 years of stellar growth, the country's economy has gone into reverse, the housing market is in freefall and the consumer is hurting.
The Labour government that presided over the good times looks set to get voted out in the forthcoming elections (sounds familiar!), and the Reserve Bank of New Zealand should cut rates to stimulate the economy. As a result, the New Zealand dollar is being sold.
The next months may prove testing for central bankers as the growth they created and exported over the past 10 years comes back in the form of inflation and a buckling consumer.
- Mark O'Sullivan is director, dealing at Currencies Direct.
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