Disappointing price growth weakened NOK

(11.02.2011) The dollar strengthened on a broad basis yesterday. However, the strengthening can largely be attributed to negative news elsewhere. ECB was forced to buy Portugal bonds yesterday, which weighed down the euro. Back home surprisingly low inflation growth contributed to a weaker Norwegian krone.

By Maren Romstad, Analyst at DNB Markets

illustration - money, euro, nok cc DNB marketsThe dollar has strengthened against the euro over the past day. The strengthening might be attributed to better figures for the US labour market than expected in advance.

After Governor Ben Bernanke’s testimony to the budget committee Wednesday, market’s attention turned to developments in the US labour market. In the mid-week speech some statements that referred to the labour market were re-written in a somewhat less pessimistic tone. It is also clear that developments in unemployment and employment will be very important for monetary policy going forward.

Yesterday we received yet another indication that the labour market is improving slowly as the number of initial claims fell more than expected. This was however not enough to lift stock markets, which were weighed by disappointing quarterly results.

But perhaps, more important for the dollar movement against the euro was ECB buying Portuguese government bonds. This was the first time ECB intervened in three weeks, which contributed to fears that Portugal is the next country to follow Ireland and Greece and seek an international rescue. The European central bank was forced back into the market, as yields on ten-year government bonds rose to a record high of 7.63 per cent. Furthermore, financial markets fear that Portugal may struggle to refinance the 9.4 billion euro maturing before the end of the second quarter.

Also against the Norwegian krone USD strengthened yesterday. This can largely be attributed to a NOK depreciation after inflation figures for January disappointed on the downside. The annual growth in core prices, measured by the CPI-ATE, was 0.7 per cent in January, which is 0.3 percentage points lower than in the previous month. The outcome was significantly lower than the consensus estimate of 1.1 per cent, and also lower than the central bank's own forecast of 0.9 per cent.

In general, imported inflation is pulling core inflation lower, and both prices on clothing and food are lower now than a year ago. However, lower imported prices are taken into account in most estimates, due to low price pressure internationally and a strong Norwegian krone.

This means that it is the domestic inflation that surprises on the downside. Domestic core inflation is on a clear downward trend. Both we and Norges Bank expect the decline in prices to have bottomed out soon, and for 2011 inflation is expected to evolve relatively flat. Although yesterday's numbers were clearly on the downside, one should be careful to attach too much weight on a single number.

But the surprisingly low inflation makes us more certain that the next interest rate hike from Norges Bank will come during the summer. In recent months, most of the surprises have increased risk of an earlier interest rate hike from the central bank. For instance, house prices and consumption growth is strong, while interest rates abroad have increased. Global growth is improving steadily, while in Norway we are approaching a normal level of activity. Yesterday's market reactions suggest that some had expected an earlier hike for Norges Bank, as interest rates pulled down and the krone weakened on a broad basis.

Also for the UK more and more are expecting Bank of England to hike their monetary policy rate soon. This is partly due to the high inflation, but what perhaps is more important is that the central bank itself considered raising interest rates on its January meeting. Most expect, however, no changes in monetary policy and yesterday's decision was no surprise. Both the rate and size of the quantitative easing program were kept unchanged. As usual, when BoE does not make any changes they don’t release any press statement. Hence, we must wait until the minutes are released in a few weeks before we get clarity in the evaluation and voting. After very weak GDP figures for the fourth quarter we expect a somewhat milder tone this time. Pound sterling also weakened against the dollar yesterday, as some hawks probably were disappointed with the decision to keep interest rates at rest.