Intense Inflation Pressures: Fed And Bank Of England Have Their Hands Tied

US industrial production fell for the second consecutive month in May, falling 0.2%, following an unrevised 0.7% decline in April. This was worse than the 0.2% gain expected as utilities posted a sharp decline in output. Overall, industrial production is down 1.1% compared to a year ago. No one can deny that industrial output is contracting, but at least it hasn’t been a rapid drop.

Meanwhile, inflation data released today showed that US producer prices in May rose at their fastest rate in six months (1.4%), although core prices excluding food and energy, gained just 0.2%. Both figures are in line with expectations. Inflation is again becoming a threat to the US economy, which recently prompted anti-inflation rhetoric from Fed officials.

US Rate Hike Pushed Back From August To September?

The decline of the US dollar yesterday and today reflects that traders are scaling back their expectations of a rate hike by the Fed as early as August, on doubts that the Fed would indeed have room for that even as the economy is still under stress.

Interestingly, former St. Louis Federal Reserve President William Poole (he retired in March) said today on TV that “we should be moving sooner rather than later” with regards to the Fed raising interest rates. He said, “I don’t think you can interpret what’s happening with energy as a temporary shock.”

His words would have carried much more weight if he hadn’t just retired, but still, they could stem the dollar’s decline as traders readjust their expectations. JPMorgan Chase and Barclays are now forecasting a rate increase in September.

Euro: Not Much Bullish Steam Either

The latest ZEW survey put out another spark from the Euro. Sentiment among German financial analysts and institutional investors plunged to its lowest level in June since December 1992 on rising oil prices and a weakening growth outlook. The data signals that economic activity in Germany -Europe’s largest economy -is slowing down after a surprisingly strong first quarter.

UK Inflation Worsens

The carefully crafted words in a letter prompted the sharp fall of the British pound today, and the currency’s prospects look very dim again. May UK consumer price inflation jumped 3.3% on the year (3.2% expected). This is the second time that the CPI is above 3% ever since the Bank of England gained independence in 1997 for setting interest rates. Since the increase is well above the BOE’s 2% inflation target, BOE governor King had to write a letter to Chancellor of the Exchequer Alistair Darling to explain why inflation is so high. So King wrote that inflation “is likely to remain markedly above the target until well into 2009″ and that the “path of bank rate that will be necessary to meet the 2 percent target is uncertain.”

Uncertain? Is he ruling out interest rate hikes? Given that fundamentals in the UK are deteriorating, the BOE may find it impossible to raise rates to fight the increasing inflation. The British pound has nowhere to go but down down down.

Forex Trading

The US dollar is slightly weaker against the Euro, Swiss franc and Japanese yen, but is a strong performer versus the British pound due to heavy shorting pressure on the pound.

EUR/USD bulls only managed to push up the currency pair up to 1.5555, near where expected resistance of 1.5560-70 lies, before bouncing almost 100 pips down to a low of 1.5460. USD/CHF declined to 1.0375, around where the support zone lies and then bounced back up above 1.0450. GBP/USD fell 230 pips from a high of 1.9700, and is now trading around 1.9500.

Economic Calendar For Wednesday:

UK BOE minutes 0830 GMT

Swiss ZEW survey 0900 GMT

US MBA mortgage applications 1100 GMT

Canada leading indicators 1230 GMT

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