McGeever: Oil slide reduces dollar's inflationary bite

The rest of the globe holds its breath when the U.S. Dollar jumps. They are waiting for the inevitable import inflation that follows. It's possible that the sound you hear is a collective sigh.

The?dollar is at its strongest in a long time against major rivals such as the euro and yen, thanks to rising U.S. interest rate expectations. The?dollar is also at multi-year highs against many emerging'market currencies, including the euro?and yen. South Korea's won fell to a 17-year-low earlier this month.

A weak domestic exchange rate increases the cost of imported materials, inputs and goods, particularly dollar-denominated commodities and energy, on which all countries depend to varying degrees. The greenback's inflationary effect is now being offset by a steep drop in global energy prices triggered the U.S. Iran interim peace agreement.

It will be a great relief to policymakers around the world, especially in Asia's energy-importing nations that were caught in a vicious cycle of exchange rates and inflation. Inflation worries push the currency down, increasing price pressures and inflation expectations.

It may be that they are closer to breaking out of this loop than what they thought a few short weeks ago.

OIL DISINFLATION

The spike in energy prices caused by the Iran War is likely to be gone as quickly as it appeared.

Energy traders are feeling confident to lower prices as the 60-day negotiating window for U.S. - Iran peace talks is underway.

Brent crude futures closed at their lowest level since the outbreak of hostilities in late February, with European gas prices down 45% and oil down 40%. Brent crude is currently below $80 a barrel and falling, while U.S. oil looks set to reach $70 in the near future.

The price of oil is now a fraction of what it was only a few months ago. Talks about $150 were common. Oil is so close to reverting to its disinflationary role it played in the year prior to the Iran War. The year-on-year difference in U.S. Crude Futures briefly became negative on Monday.

'MATERIAL CHANGE'

This rapid shift helps to temper inflation expectations around the world, by offsetting the impact of an increased dollar.

The adjustment in Europe is especially noticeable.

Nomura Capital Markets and RBC Capital Markets revised their European Central Bank forecasts on Tuesday, each removing a quarter point rate hike. Nomura expects to see two rate hikes over the next few months. RBC is calling for only one.

RBC's economists noted that the euro zone inflation dynamics may mean-revert relatively quickly.

This already seems to be happening. The market-based inflation expectation, as measured by the one-year euro-zone inflation swaps, has dropped to 2.45%, from nearly 3.90% a few months ago. And the five-year rate is now at 50 basis points below the ECB’s 2% inflation target.

In Britain, the two-year swap rate, which is a major factor in determining fixed-rate mortgage prices, has returned to its pre-war level. UK rate futures are only pricing in one Bank of England interest rate hike for this year. This is down from three just a few months ago.

RELEASING PRESSURE

The pressure on countries to tighten their policy or intervene on the FX markets is decreasing, despite the fact that the dollar remains strong.

It may explain why Japan imports 90% of its energy and doesn't intervene to support the yen which is hovering near a 40 year low at 162 per dollar.

This is lower than the levels that triggered multiple rounds in recent years of record-breaking yen buying intervention, including the most recent in April when the dollar rose above 160 yen.

Brent crude, however, was above $125 per barrel at the time. Satsuki Katayama, the Japanese finance minister's latest threats to intervene would be more credible if oil wasn't under $75.

A number of central banks have taken action to reduce inflationary pressures. The ECB has raised rates, as have the Reserve Bank of Australia, Norges Bank and the Reserve Bank of Australia. Several emerging economies have taken even more drastic measures: Bank Indonesia raised rates in an emergency, Central Bank of Sri Lanka increased by 100 basis points last May and Reserve Bank of India intervened frequently to support the rupee.

The pressure?valve is now open, giving policymakers in the world some breathing space.

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(source: Reuters)