The dollar dropped against its rivals Wednesday on rising inflation fears as commodity prices rose and US stocks fell. Both European Central Bank and Federal Reserve officials warned about inflation. Fed Vice Chairman Donald Kohn warned about rising inflationary expectation but also said 'appropriate monetary policy following a jump in the price of oil will allow, on a temporary basis, both some increase in unemployment and some increase in price inflation.' Bringing overall inflation immediately back to the low rate consistent with price stability could be associated with a much higher rate of unemployment than acceptable, Kohn added. This shows the Fed's dilemma as it cannot simultaneously reduce inflation and stimulate economic growth with one policy tool, interest rates. The US needs tighter monetary policy to fix the inflation problem and tax cuts to stimulate economic activity, similarly to the economic policy mix in the early eighties.

The EUR/USD rose modestly today as Kohn's comments seemed to rule out aggressive Fed rate hikes. In the last four volatile trading days both support at 1.54 and resistance at 1.58 were tested. The pair has been in the same trading range for seven weeks. The EUR/USD is in a well-defined long uptrend; however, having been in a sideways pattern since March on optimism the US economy would stabilize and the Fed would reverse its super-easy monetary policy stance. A penetration of resistance would be bullish for the EUR/USD, while a break of support would be bearish.

Financial and Economic News and Comments

US & Canada

• According to the Federal Reserve's Beige Book, 'economic activity remained generally weak in late April and May' as consumer spending slowed. Three of the 12 regional Fed banks reported 'softer, weaker or lower' growth and four found 'slower, sluggish or modest' expansion. 'Consumer spending slowed since the last report as incomes were pinched by rising energy and food prices.' 'Business contacts in most districts reported moderate or limited wage growth in response to some loosening of labor market conditions.' 'Reports of softer demand for housing-related products remained widespread,' the Beige Book said.
• Federal Reserve Vice Chairman Donald Kohn said limiting price expectations is critical. 'It is very important to ensure that policy actions anchor inflation expectations' and thereby help contain price gains, Kohn said at a conference hosted by the Boston Fed in Chatham, Massachusetts. 'This anchoring is critical.'
• The US government turned in a $165.93 billion budget deficit for May, a record for that month, compared to a year-earlier deficit of $67.70 billion, the US Treasury said.
• Canada's Q1 2008 capacity utilization fell to 79.8%, the lowest since 1992, Statistics Canada reported.
• Canada's new home prices increased 5.2% y/y in April, the slowest pace since 2006, down from March's 6.1% y/y rise, Statistics Canada said. On a month-on-month basis, prices were unchanged in April.
• Global confidence fell as central banks signaled higher interest rates, according to a survey of Bloomberg users on five continents. The Bloomberg professional global confidence index declined to 21 in June from 22.7 in May. A reading below 50 indicates negative sentiment.
  

Europe

• UK jobless claims, increasing for a fourth month in May, rose a more-than-expected 9,000 to 819,300, a 7- month high, data from the Office for National Statistics showed. UK unemployment, measured by International Labor Organization standards, was 5.3% in the three months to April. The figures indicate the UK labor market is weakening at a time when Bank of England policy makers have little scope to cut interest rates and prevent a recession because of the threat of rising inflation.
  

• The UK's trade in goods balance with the rest of the world showed a deficit of ?7.6 billion in April, compared with ?7.1 billion in March, the Office for National Statistics said. The UK's trade with the EU showed a deficit of ?3.4 billion in April, unchanged from March. The deficit with non-EU countries widened to ?4.2 billion from ?3.8 billion. The UK's trade in services position improved slightly to a surplus of ?3.3 billion from ?3.4 billion. This took the total trade in goods and services to a deficit of ?4.3 billion in April from a deficit of ?3.8 billion in March.
• European Central Bank council member Athanasios Orphanides said ECB interest-rate increase is possible after July. ECB President Jean-Claude Trichet 'did not indicate that the Governing Council was to embark on a path of rate increases,' but 'one cannot rule out that subsequent data developments may be such that additional adjustments may be necessary,' Orphanides said in Chatham, Massachusetts.
• ECB Executive Board Member J?rgen Stark said late yesterday that 'markets have understood' the ECB's signal about a single interest-rate increase in July, though he discounted 'a series of rate increases.'
  

Asia-Pacific

• Australian consumer confidence fell to a 16-year low in June following record oil prices and the Reserve Bank of Australia's rate-increase signal. The consumer sentiment index dropped 5.6% to 84.7 in June, the fifth straight reading of less than 100, showing pessimists outnumber optimists, according to a Westpac Banking Corp. and Melbourne Institute survey. The measures for current condition, expectations, and economic conditions in the next 12 months also fell in June, showing readings of 78.5, 88.8, and 74.4, respectively.

FX Strategy Update