Oil has been a major driving force in the financial markets in recent weeks. When oil hit fresh record highs of over USD147 a barrel on July 11, stocks plunged and US dollar fell to historic lows of around 1.60 against the euro. When oil prices later dived below the USD130 level, the dollar subsequently rebounded against majors. The importance of oil stems from the fact that its prices are already at historical highs, in both nominal and inflation adjusted terms. If prices rise further, it would weigh on both consumers and businesses, possibly sending the global economy into a protracted slowdown.

Apart from oil, dollar sentiment was also affected by Fedspeak and developments in the credit market. The minutes of the June 25 FOMC meeting showed that some Fed officials favoured an interest rate hike to curb rising inflation pressures. However, recent developments in the credit market have virtually ruled out any chance of a rate hike this year.

The decline in house prices have raised doubt about the "solvency" of Fannie Mae and Freddie, causing their share prices to plunge and credit spreads to widen. Treasury Secretary Henry Paulson had to announce a plan, involving expanding direct credit lines to the two mortgage giants, permitting them to access the Fed's discount window, and the government potentially purchasing their shares, to help calm market concerns. Fannie and Freddie's woes show that the credit crisis is by no means over and would continue to weigh on investor sentiment.

Looking ahead, economic data, unless they deviate substantially from market expectations, are likely to play a secondary role. Oil and equities would continue to drive the price action of the US dollar.

Central banks everywhere are in a dilemma, but even more so for the Fed. With inflation rising, the Fed should be hiking interest rates. However, the US central bank could not ignore growth risk, which is also rising.

In his semi-annual testimony to the House Banking Committee on July 15, Fed Chairman Ben Bernanke acknowledged that both growth and inflation risks were increasing. He cited higher energy prices, reduced access to credit and a further deepening in the housing sector as dangers to growth. At the same time, the Fed Chairman feared a gradual pass through of high oil prices to the prices of other consumer goods and that if high level of inflation was sustained, it could lead the public to revise up its expectations for longer-term inflation. In fact, FOMC members have marked up their forecast for inflation for 2008 to 3.8%-4.2% from their April projection of 3.1%-3.4%.

Apart from having to contend with increasing growth and inflation risks, the Fed has to deal with a deepening credit crisis. The latest is the yet to be resolved problems at the two mortgage giants, Fannie Mae and Freddie Mac, which forced the Fed to temporarily open its discount window to them and the Treasury to announce a rescue plan last week. Under such circumstances, the Fed would have no leeway to hike rates despite higher inflation. We therefore expect the fed funds target rate to remain at 2% for the remainder of the year.

Across the Atlantic, economic conditions are deteriorating fast, but inflation is also rising, well beyond central bank targets. The European Central Bank and the Bank of England might like to hike rates to maintain price stability, but they run the risks of sending their economies in recession. As such, we expect the ECB and BOE to keep their benchmark rates at 4.25% and 5% respectively until the year end.

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