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Markets resilient in face of Middle East crisis

Oil prices surged to new peaks of $78/barrel, but the financial markets have
been remarkably resilient in the face of the conflict. In July and August,
equities and emerging market assets have recovered some of their previous sharp
losses. We have even seen some renewed appetite for risk. But new anxieties have
emerged. The key factor eroding confidence is the worrying evidence, mostly in
the US, that faltering growth is coinciding with higher inflation. If
stagflation is a reality, the central banks will face unpleasant choices.

US Interest rates Weak US job figures since April, and sharply slowing US
growth in Q2, to 2.5% annualised, have persuaded the Fed to pause in August at
5.25%, after 17 increases at every FOMC meeting since June 2004. But a pause is
not a halt. With US inflation rising more than previously expected, the market
consensus expects on balance one or two further rises in the Fed funds rate in
the current cycle, to 5.50% or 5.75% in Q4 2006. But sizable minorities are
questioning this tentative consensus. One group expects eventual increases to 6%
or even higher. Other groups believe that the US Fed funds rate has peaked
already at 5.25%.

European rates The ECB is in a hawkish mood. Having raised its official
interest rate, as expected, to 3% on 3 August, the markets expect further ECB
increases to 3.50% by end-2006, and to 4% by mid-2007. In the UK, the Bank of
England surprised the markets by raising rates in August to 4.75%.

Dollar The US dollar came under strong downward pressures towards the end of
July and early in August. Ben Bernanke’s ‘dovish’ testimony to Congress on 19
July, and weak US GDP and job figures, anticipated the Fed’s decision to pause
and weakened the dollar. Looking forward, the markets expect further net falls
in the US dollar over the next two years (even though the Fed is still likely to
raise rates further), because of the huge US deficit and the prospect that
central banks will reduce the share of the US dollar in their forex reserves.

David Kern, of Kern Consulting, is economic adviser to the British
Chambers of Commerce. He was formerly NatWest Group Chief Economist.

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