Caught between Fed rate cut and inflation threat

(PATRICK CASTILLO)   

All the Gulf states, except Kuwait, have pegged their currencies to the US dollar, leaving them with no choice but to reflect Fed rate moves. This gives them little room to manoeuvre their monetary policies.

Prices in the region have been growing at unprecedented rates and Qatar, where the inflation rate is the highest, is considering linking its riyal to a basket of currencies or revaluing it to tame spiralling inflation, an economic adviser to the country’s ruler said in remarks published yesterday.

But Qatar firstly needed “to have financial institutions that can effectively deal with the repercussions of any such move”, The Gulf Times quoted Ibrahim Al Ibrahim as saying. “Pegging the riyal to only one currency has many disadvantages, especially if that country adopts monetary policies that clash with ours,” he said.

“For that reason, pegging to a basket of currencies is preferred by experts,” added Al Ibrahim, also a member of a committee set up by the state to look into ways to curb inflation.

Saudi Arabia on Monday said it will raise wages, welfare payments and subsidies to counter rising disaffection over inflation, which has surged to a 16-year high as the central bank cut interest rates to defend the riyal’s peg to the dollar.

Resentment over the rising cost of living led the king’s advisers to summon the central bank governor and finance minister next month to discuss the peg, which has forced the central bank to slash rates by 150 basis points since September.

With more US rate cuts likely and Gulf central banks under pressure to follow to avoid currency appreciation, investors are betting Saudi Arabia and its neighbours will give up on their pegs and focus on fighting inflation.

Inflation, which hit 6.5 per cent in Saudi Arabia in December, has “many negative repercussions for the livelihood of citizens”, the official Saudi Press Agency said on Monday, citing a cabinet statement.

The government of the world’s largest oil exporter will increase public sector wages and pensions by five per cent for three years, the agency said. The cabinet also agreed to raise social insurance benefits by 10 per cent and subsidise half the cost of shipping and some administrative expenses, including those for driving licences and passports, it said. The agency did not say how much the measures would cost.

Unable to raise interest rates, many Gulf nations are resorting to subsidies and price controls to cushion their populations from rising prices. Qatar, Oman and the UAE have imposed ceilings on rent increases.

Most Gulf states have either raised public sector wages or said they are considering similar steps.

Policymakers in all six countries have said reform is being discussed and that the neighbours could revalue their currencies together to preserve plans for monetary union. Oman’s central bank yesterday slashed its repurchase rate by 61 basis points and cut the yield on certificates of deposit in its first auction since the emergency US rate cut.

Inflation in Oman hit a 16-year high of 7.57 per cent in November. Oman, which sets monetary policy at a weekly auction of CDs, set the repurchase rate at 4.32 per cent as of yesterday, from 4.93 per cent a week earlier, the central bank said.

The one-month CD rate has fallen 90 basis points since the last auction in December. The central bank accepted OR11.3 million (Dh11.3m) of bids of a total OR378.5m submitted, it said.

When the US Federal Reserve slashed its benchmark interest rate by 75 basis points last week, only the UAE matched the cut, while Kuwait, Qatar, Saudi Arabia and Bahrain opted for reductions of half a percentage point. (Agency reports)

Fed may slash interest rates below inflation

The Federal Reserve may push interest rates below the pace of inflation this year to avert the first simultaneous decline in United States household wealth and income since 1974.

The threat of cascading stock and home values and a weakening labour market will spur the Fed to cut its benchmark rate again, traders and economists forecast.

The rate is already close to one measure of price increases monitored by the Fed. “The Fed is going to have to keep slashing rates, probably below inflation,” said Robert Shiller, the Yale University economist who co-founded an index of house prices. “We are starting to see a change in consumer psychology.”

So-called negative real interest rates represent an emergency strategy by Chairman Ben S Bernanke and are fraught with risks. The central bank would be skewing incentives toward spending, away from saving, typically leading to asset booms and busts that have to be dealt with later.

Negative real rates are “a substantial danger zone to be in”, said Marvin Goodfriend, a former senior policy adviser at the Richmond Fed bank. “The Fed’s mistakes have been erring too much on the side of ease, creating circumstances where you had either excessive inflation, or a situation where there is an excessive boom that goes on too long.”

New policy

Economic growth could be replacing interest rates as a primary driver for currency markets.

The foreign exchange market expects a dollar rally if the United States Federal Reserve delivers a 50-basis-point interest rate cut.

Such a change in the $3.2 trillion-a-day (Dh11.7trn) global foreign-exchange market would be a 180-degree departure from the past pattern that favoured higher-yielding currencies. For the past few years, traders have pushed up currencies with high interest rates and clobbered those with low rates.

But now that relationship appears to be breaking down. If the new thinking takes hold, traders and investors could start consistently rewarding currencies linked to rate-reducing banks.

An early sign came from the dollar’s reaction last week when the Fed pitched the market a surprise interest rate cut on January 22. “On the face of it the Fed cut could have been seen as dollar negative, but that’s not the case,” said Mitul Kotecha, head of currency strategy at Calyon in London.