Intelligentguess

 Situation

The Federal Open Market Committee (FOMC) is scheduled to announce their decision on the  benchmark rate at about 2:15 p.m today. ( Washington time)

Background 

1. Consumer Prices ( CPI) have been rising moderately ( and could rise some more in the coming 2-3 months)
2. Producer Prices ( PPI)  has risen sharply since Oct’06. ( from a negative rate rate in Oct’06 to  2.53 % in Feb’07 ) 
3. Gross Domestic Product ( GDP ) has performed better in  Q4 2006 (as compared to Q 3 2006). It MAY not do as well  from Q2 2007 onwards .( see : Production and New Orders )
4. The CBOT 30-Day Federal Funds futures contract for the April 2007 expiration is currently pricing in a 2 % probability that the FOMC will decrease the target rate by at least 25 basis points from 5.25% percent to 5 % at the FOMC meeting on March 21 (versus a 98 percent probability of no rate change).
5. Traders are betting on a cut by the end of August, futures show ( this could be more due to the expected effects  of  Production and New Orders  on GDP)

Conclusion

It is expected that the rate will be retained at 5.25% for now.

Inflation ( CPI ) could be picking up over the next 2-3 months. IF the expectations of a drop in GDP are correct - it will be very interesting  to see on which side of  the interest rate fence ( raise or drop ??) - the Fed Chief - Ben Bernanke will land on.

Doing nothing could just be the best bet ??? ( dropping the benchmark rate will have a negative effect on the savings rate )

Ponder on this

Former Fed Chairman Alan Greenspan, speaking to a business conference in Hong Kong (end Feb’07) , had said, “When you get this far away from a recession, invariably forces build up for the next recession. For example, in the U.S., profit margins…. have begun to stabilize, which is an early sign we are in the latter stages of a cycle.

But then he adds, “…it would be very precarious to forecast that far into the future, I can not rule out the possibility of a recession late this year.”

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Situation

On an annual basis - the Consumer Price Index ( CPI) has risen marginally in Feb’07 to 2.78% p.a ( up from 2.69% p.a in Jan’07) .

As compared to the previous month  prices have risen by 0.29% in Feb’07 ( flat in Jan’07)

Note

1. The Bank of Englands inflation target is at 2% p.a. This is expressed in terms of an annual rate of inflation based on the Consumer Prices Index (CPI).
2. Producer Price Index  PPI has been growing since November 2001 ( - 1.39 % p.a) and peaked out in 2004 December (  3.54 % p.a ) . Since then PPI was ranging between 3.4 % p.a and 2.4 % p.a .  PPI has started dropping since June 2006 from 3.4 % p.a to 1.58 % p.a in October 2006 ( lowest since March 2004) . It is currently at 2.20 % p.a ( Feb’07) . As can be seen in the chart PPI direction tends to lead the CPI.
3. CPI has been growing since June 2002 ( 0.63 % p.a) and peaked in December 2006 ( 2.97 % p.a ) .
4. The Bank of England raised the Bank Rate by 0.25% to 5.25% in January 2007.

Conclusion ( click / double click on picture for a better Visual)

PPI has had a strong drop , and does not look like it will have any sharp rises in the immediate future. It would most probably range between the 1.25% - 2.50% area.

The CPI look like it has peaked , and based on its behaviour viz a viz PPI - it could be expected to propably range initially ( 2.30% - 2.90 % ) and then drop down towards/below 2%. ( the Banks target rate).

The Result

- It is unlikely that the Bank of England will raise interest rates for the immediate future.
- IF the rate drops below 2% ( a possibility - post 6 months ) - the Bank of England would need to consider possibly - dropping interest rates.

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After yesterday’s sharp rise in overnight money rates in the Indian markets, market participants had been bracing for more pain when trading resumed today.

And painful it has been.

•  Overnight money rates for clean lending / borrowing are ruling at close to 10 year highs of 60%. (Whatever happened to RBI’s professed aim of keeping overnight rates within the LAF corridor)
• Surprisingly, the rate for collateralised borrowing / lending opened at 20% and has subsequently eased to about 12% (at the time of writing - 0530 hrs GMT)
• The Indian Rupee (INR) has appreciated further to 43.62 to the US dollar, signifying renewed dollar sales by banks
• Cash - Tom, Cash-Spot, Tom-Spot rates in the fx markett have moved up to reflect the increased cost if money
• Government bond prices have remained stable in spite of the spike in money rates

From the above facts and informal discussions with market participants, I can only infer the following

• The sharp rise in clean uncollateralised money rates can be partly attributed to the shortage of deliverable securities, for collateralised borrowing with the banking system. This is also corroborated by the fact that rates for collateralised borrowing / lending have not moved up in tandem.

• The spike is also, possibly, linked to the proposed strike by workers of state owned banks currently scheduled for March 28, 29, 30. The strike, if it does go through, is expected to cripple banking operations for about a week

This has prompted borrowers to cover their positions in advance, leading to the sharp spurt in rates.

Update : The Finance Minister promises that the liquidity cruch will ease in a few days.

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