JANE FOLEY<br /><strong>RESEARCH DIRECTOR, FOREX.COM</strong><br /><br />WE might still be knee deep in recession, but policy makers have started to talk about how they will mop up in the aftermath of their generous fiscal and monetary incentives. In essence, it is prudent that this discussion takes place now. Even when deflation was a real fear in many parts of the global economy, some saw a sharp rise in inflation as a strong threat in three to five years. This fear of inflation can be linked to the sheer size of fiscal and monetary policy responses made in recent months.<br /><br />Also, the unprecedented nature of the quantitative easing taken by some central banks means it carries no guarantee that a reversal will be easy. If policy makers do not have clear exit policies in place, signs of economic recovery will be associated with a rise in inflationary concerns, which in turn could prompt an overly aggressive response by the markets. Prices of commodities, considered a hedge against inflation, will be pushed higher by speculative demand and long-term interest rates will also increase, potentially too far.<br /><br />But the irony is that higher interest rates and commodities prices could in turn trample the green shoots of recovery, which prompted the more optimistic economic outlook in the first place. At the start of this month there was a danger of such a reaction &ndash; the market was toying with the prospect of two Fed rate hikes by year-end, though a dose of reality has ensued, paring back these expectations.<br /><br /><strong>PRICE STICKINESS</strong><br />Central bankers will have a difficult line to tread as the recovery sets in. Policies will have to support growth at least through 2009 but consideration will have to be given to the management of longer-term inflation expectations. The job facing the Band of England (BoE) will potentially be complicated by the stickiness of the Consumer Prices Index (CPI). Last week&rsquo;s May CPI release showed that inflation at 2.2 per cent year-on-year is still, unexpectedly, above the BoE&rsquo;s 2.0 per cent target.<br /><br />The CPI is set to fall in the coming months as last year&rsquo;s energy price rises fall out of the index, but UK inflation is taking longer than expected to ease, potentially due to sterling weakness. On the margin this could mean that the Bank of England will be forced into its exit policies a little sooner than has been anticipated.<br /><br />While central bankers have a difficult job ahead of them, they have the advantage of not being elected officials. Exit policies from government fiscal incentives mean austerity budgets. Weak governments &ndash; or those facing general elections &ndash; are not too successful in implementing budget reform. Yet the UK government has little choice but to face up to the sharp deterioration in the budget deficit which the Economist Intelligence Unit forecast at 13.8 per cent of GDP this year. When Standard &amp; Poor&rsquo;s warned about UK debt on 21 May, it focused attention on the issue of government deficits and debt, and not just in the UK either.<br /><br /><strong>BOTTOMING ECONOMY</strong><br />The UK may have one ace up its sleeve, however: most recent economic data shows that the UK recession may have troughed and some economists have been brave enough to declare that the recession is already over, although many more prefer to forecast growth in the fourth quarter, perhaps even in the third quarter.<br /><br />The release of UK unemployment data last week is consistent with the notion that the UK economy is bottoming. The rate of layoffs declined to 393,000 in May from 571,000 in April; it is likely to be 2010 before unemployment actually declines. If growth is restored by year-end, then the associated increase in tax receipts will bring some relief to the country&rsquo;s coffers.<br /><br />Since March, sterling has rallied significantly versus the US dollar and the euro. Sterling-dollar is dominated by the market&rsquo;s changing appetite for dollars, meaning that euro-sterling offers a clearer picture on how much risk is reflected in the price of the pound. Despite the push lower in euro-sterling since March, the pair is still 27 per cent higher than pre-Northern Rock. Last week&rsquo;s profit-taking on sterling longs was a natural reaction to the gains registered in early June.<br /><br />However, the likelihood that the UK economy will see growth ahead of the Eurozone and the greater degree of transparency in the UK banking system suggest that the pound can make further progress against the euro during the summer. Whether or not euro-sterling can move back to the 0.650 level longer-term depends on how successful policy makers are in reining in the budget deficit and managing growth and inflation.<br /><br />Please send questions or comments to<br />