Recent commentary from various FOMC members suggests that the instability in the markets remains of major concern, but given the two dissenting votes we saw during the March meeting by members Fisher and Plosser in favor of “less aggressive” policy, it is clear that many are worried about mounting inflation pressures. Indeed, the release of the US producer price index reflected surging energy and food costs. However, the most disconcerting part of the report was that even the core measure (which excludes volatile items) rose at the fastest pace since July 2007. Clearly, price pressures are building throughout the economy, suggesting that Wednesday’s CPI figures could be stronger-than-expected. Furthermore, the news may ensure that the FOMC will only cut the fed funds rate by 25bp at the end of the month.

Yield Spread Analysis 04/08 – 04/15

In most regions, government bond markets have been relatively quiet over the past week. One notable move came in short-term European yields, as rates on 3-month Euribors surged almost 13bps amidst hawkish commentary from ECB President Trichet and other monetary policy makers in the region. Indeed, with inflation growth continuing to accelerate, the ECB is highly unlikely to cut rates anytime soon. Likewise, short-term yields in the US show that the markets are anticipating less aggressive policy action at the Fed’s next meeting on April 30, given persistent price pressures.

As a result of these inflation risks, Wednesday’s US CPI release will likely be market-moving for Treasuries and the US dollar, especially if the report proves to be stronger-than-expected. Meanwhile, the release of Canadian CPI on Thursday could impact Canadian government bonds and the Loonie, especially as the figure is forecasted to reflect softer inflation.

US Fed: Building Inflation Will Likely Ensure A Mild 25bp Cut on April 30

Recent commentary from various FOMC members suggests that the instability in the markets remains of major concern, but given the two dissenting votes we saw during the March meeting by members Fisher and Plosser in favor of “less aggressive” policy, it is clear that many are worried about mounting inflation pressures. Indeed, the release of the US producer price index reflected surging energy and food costs. However, the most disconcerting part of the report was that even the core measure (which excludes volatile items) rose at the fastest pace since July 2007. Clearly, price pressures are building throughout the economy, suggesting that Wednesday’s CPI figures could be stronger-than-expected. Furthermore, the news may ensure that the FOMC will only cut the fed funds rate by 25bp at the end of the month.

Ben Bernanke, Federal Reserve Chairman (Voting Member)

“Healthy, well-functioning financial markets are essential to sustainable growth.” – April 11, 2008

“We do not have the luxury of waiting for markets to stabilize before we think about the future.” – April 11, 2008

Donald Kohn, Federal Reserve Vice Chairman (Voting Member)

“I don't think we can prevent the kinds of waves of optimism and pessimism that pass over the market particularly when there have been innovations. There will be future events - I think our role…as regulators is to try and make the system more resilient.” – April 14, 2008

Kevin Warsh, Federal Reserve Governor (Voting Member)

“We have reduced the policy target rate by a cumulative 3 percentage points since August. These actions, together with significant actions to support liquidity, are intended to promote growth and mitigate downside risks to economic activity. Consistent with our dual mandate of promoting maximum employment and stable prices, we also need to be alert to risks to price stability. Increases in food and energy prices have pushed up overall consumer prices and are putting upward pressure on core inflation and inflation expectations.” – April 14, 2008

Richard Fisher, Federal Reserve Bank of Dallas President (Voting Member)

“We've seen yet another historical cycle of excess risk-taking -- in this case, concentrated in financial innovations in credit and structured finance served up and consumed without regard to the downside -- followed by extreme risk aversion.” – April 10, 2008

Alan Greenspan, Former Federal Reserve Chairman

“We are in the throes of a recession.” – April 9, 2008

ECB: How Long Can They Remain Hawkish Before Rates Cripple Growth?

The European Central Bank has not backed off from their hawkish inflation bias by any means, and with good reason: CPI remains well above their comfort zone and upside inflation risks persist. However, is the ECB a bit too optimistic about growth prospects? Thus far, many European monetary policy makers have indicated confidence that their economy will continue to perform well. Nevertheless, the marked deterioration of financial market and economic conditions witnessed in the US and UK over the past few months may be on the way for the Euro-zone, and restrictive monetary policy in the region may not help the case.

Jean-Claude Trichet, European Central Bank President

“It is necessary not to lose sight of fact that we are and have experienced growth and prosperity at a global level in a manner which was absolutely unprecedented. At a global level we see continued growth.” – April 15, 2008

“Against the background, we emphasize that maintaining price stability in the medium term is our primary objective in accordance with our mandate. The firm anchoring of medium to longer-term inflation expectations is of the highest priority…We believe that the current monetary policy stance will contribute to achieving our objective.” – April 10, 2008

Axel Weber, European Central Bank Governing Council Member

“There is no leeway at all to discuss a rate cut. Inflation in the Euro-zone is likely to have peaked in March - a preliminary estimate for the month showed consumer inflation at an annual clip of 3.5 percent - but the consumer price index is expected to stay above 3 percent for most of the year before falling below 3 percent toward the end of the year.” – April 11, 2008

Miguel Angel Fernandez Ordonez, European Central Bank Governing Council Member

“It (March euro zone inflation) is a worrisome figure that reflects the strong upward pressures in the short-term noted by the increase of energy and food prices during the last months.” – April 15, 2008

“It's evident that with 3.5 percent inflation in Europe we should be worried and this is what has made us, since June, not cut interest rates when other banks have been cutting interest rates. We consider reducing inflation is the priority.” – April 15, 2008

Juergen Stark, European Central Bank Executive Board Member

“In my view the euro area seems to be more resilient against external shocks than it was at the beginning of the decade. Price stability is the key mandate of central banks worldwide.” – April 15, 2008

Guy Quaden, European Central Bank Governing Council Member

“The current Euro-zone inflation level is clearly above our definition of price stability and the growth outlook for coming months in not really reassuring.” – April 14, 2008

Richard Lee is a Currency Strategist at FXCM.