JANE FOLEY<strong><br />RESEARCH DIRECTOR, FOREX.COM<br /></strong><br />LAST week brought confirmation that prices actually fell in the Eurozone in June. The consumer prices index (CPI) fell 0.1 per cent year-on-year, in sharp contrast to the European Central Bank’s (ECB) mandate which directs it to keep inflation at, or a little below, 2.0 per cent year-on-year. The complete absence of price pressures suggests that the huge amount of stimulus that both the ECB and governments have thrown at the economy is not yet having the desired effect. <br /><br />Granted, there has been an improvement in confidence in Germany as shown by the key IFO business and ZEW investor surveys but both of these surveys suggested that the current conditions component remains relatively depressed. <br /><br />One key concern for policy makers is that the extra liquidity that has been offered to banks in recent months has not turned into an increase in the availability of credit for the broader economy. Without credit being available to consumers and business, the risks of a more protracted recession increase. This is a concern for the Bank of England (BoE) as much as the ECB. <br /><strong><br />ENHANCED LIQUIDITY</strong><br />The rhetoric of central banks has made it clear that they are well aware that the supply of credit to businesses and consumers has not yet returned to normal. The Federal Reserve and the BoE are hoping that their massive quantitative easing (QE) programmes will be instrumental in restoring the balance. The ECB has instead gone down the route of enhanced liquidity provision through which a huge amount of cheap funds have been provided to the banking sector for periods of up to 12 months. <br /><br />While the ECB’s method is technically very different to QE, it is similar insofar as it still provides funding to banks which, it is hoped, will be passed on. In spite of the ECB’s efforts to promote lending to the broad economy, its own data shows that the growth rate of loans to the private sector has now fallen to 1.8 per cent, which is the lowest rate since the launch of the euro in 1999. <br /><br />UK lending numbers have been just as disappointing. Recent BoE data for April showed the weakest flow of net lending to businesses since June 2000 and in May total net lending to individuals was £0.6bn, lower than both the April increase and the previous six-month average. Other economic data has also been bringing bad news: UK markets were taken aback last week by a far greater-than-expected downward revision to the UK’s first quarter GDP. The economy contracted by 4.9 per cent year-on-year, the largest fall on record. While second quarter data is showing that the economy is bottoming, the contraction has now been shown to be far deeper than previously thought so the return to growth could indeed be a long hard slog. <br /><br />US recovery hopes also suffered a setback last week. The widely watched jobs data described a worse picture of the US labour market than had been expected. The unemployment rate has risen to 9.5 per cent from 5 per cent in one year, prompting the view that the US and global recovery may be further away than had been hoped.<br /><strong><br />EXIT POLICIES</strong><br />On balance, it seems probable that the focus of central bank policy will remain tilted towards stimulus for some months, so talk of exiting these policies is still premature. The negative CPI rate in the Eurozone, expectations that UK inflation will drop sharply in the months ahead and general reining in of optimism about recovery all seem to push fears of inflation into the shadows. However, the market should remain mindful of inflation on a three to five year view. The huge amount of liquidity in the system combined with the prevalence of very low interest rates suggest the possibility of a very sharp bounce back in lending down the line.<br /><br />There is a rule of thumb that monetary policy changes can take up to 18 months or so to fully work through the system suggesting none of the policy measures taken since the height of the financial crisis ha completely worked through the economy. A sharp rise in the availability of credit and an associated jump in demand could stress inventory levels and stimulate inflation.<br /><br />The monetary authorities have been keen to stress that exit policies will be able to prevent inflation, but clearly there are no guarantees. Thus longer term inflation concerns do have some validity.<br /><br />Near-term, as long as the market is wary about the outlook for global growth, low risk strategies may be favoured by the markets. The US dollar is likely to find decent support and sterling-dollar is looking vulnerable given its recent rally and revival of economic concerns.