In this note, we introduce a hypothesis to explain why G10 exchange rates have become so sensitive to nominal short-term interest rates in the past couple of years. Distinct from the popular view about ‘carry trades’ being the driver of exchange rates, our idea is that, with the extraordinary growth in cross-border financial asset holdings in recent years, the need to hedge against currency risk has risen commensurately. Since most of the hedging is done through relatively short-term instruments (3M forwards or swaps), nominal cash yield differentials have become important drivers of exchange rates. Technically, this could be considered a form of ‘carry trade’, but it is conceptually very distinct from the type of ‘carry trade’ we think most people have in mind. One implication from this hypothesis, if it is right, is that nominal interest rate differentials as a key driver of exchange rates will be a permanent feature of currency markets, and will not fade with changing risk appetite. The world’s fixation on ‘carry trades’ There is a prevailing view that currency trades that involve borrowing in low-yield currencies (such as the JPY and CHF) and lending in high-yield currencies have been rampant and have been key in keeping the JPY and CHF weak in recent quarters. While many investors were doubtless indeed involved in these trades, we have long argued that much of the short-JPY positions in the market were the result of capital outflows, and not ‘carry trades’ per se. Specifically, we have pointed out that Japanese retail investments in foreign equities have been around 7-8 times the size of those in foreign bonds. This distinction between capital outflows and ‘carry trades’ is important because the former are sensitive to the overall buoyancy of global equity markets, while the latter are sensitive to changes in policy interest rates. The other nagging problem we have with the ‘carry trade’ notion is that nobody seems to be able to find indisputable proof that ‘carry trades’ have dictated currency trends, even though G10 exchange rates have clearly moved in ways that are consistent with the ‘carry trade’ argument. In its Article IV report on Japan, the IMF cites a wide range (US$100 billion to US$2 trillion) of estimates of ‘carry trades’ in the world, but suspects that the real number is closer to the lower end of this range. This is also our hunch. Additionally, the recent report by the BIS (its latest Quarterly Report) on carry trades cites evidence that is more circumstantial than definitive. Our hypothesis may help explain the link between cash yield differentials and spot exchange rate movements. Our hypothesis We propose a hypothesis to help explain the close correlation between the cash yield differentials and the G10 exchange rates, due to a factor unrelated to ‘carry trades’. Specifically, we point out that, because cross-border asset holdings have surged exponentially in recent years – this being a part of financial globalisation – the size of currency hedging has also risen sharply. Since most of the currency hedging instruments are relatively short term in nature (i.e., three months in duration or shorter), short-term nominal interest rates are important now because they determine the cost of hedging. Further, to the extent that fund managers have become more active managers of their currency exposure, changing interest rate costs of hedging may also drive the ‘hedge ratios’. For example, if US investors have 100 units worth of exposure in the Nikkei, and Japanese investors have the same amount of equity holdings in the US, when the US cash interest rate premium rises, ceteris paribus, US investors should raise their hedge ratios while Japanese investors should lower their hedge ratios. Thus, short-term interest rate changes, through currency hedging, could have an impact on exchange rates that has nothing to do with ‘carry trades’. Furthermore, if these investors now have 220 units of exposure in each other’s stock markets, small changes in interest rates could have a much larger effect on spot exchange rates. In fact, G10 cross-border gross assets have grown by a multiple of 2.2 since 1999. Gross foreign assets and liabilities have grown sharply in recent years. For G10 countries, total foreign assets have grown from US$22.8 trillion in 1999 to about US$50.4 trillion in 2006 (equivalent to about 96% of GDP in 1999 and 149% in 2006). Total foreign liabilities have witnessed a similar trajectory, rising from US$22.5 trillion in 1999 to US$53.1 trillion in 2006. We make the following observations: · Observation 1. The growth in cross-border gross asset holdings is astonishing, particularly since 2003. Our sample includes the G10 countries (though the chart only shows the major G10 economies). From 1980-2002, these cross-border financial holdings did not increase significantly. Even after the establishment of the EMU in 1999, growth was anaemic. However, since the launch of the EUR notes and coins in 2002 or so, these cross-border asset holdings exploded in most countries, especially the EMU, the US and the UK. In fact, since 2003, gross asset and liability positions of the G10 have doubled. In other words, most of the growth seen since 1999 came from the post-2002 period. · Observation 2. This growth has been concentrated in countries with large and developed financial markets. Even correcting for market and economy size, the Eurozone, the US, Japan and the UK – the four largest financial markets – witnessed the sharpest growth in gross foreign asset and liability positions. This is consistent with a point we made previously that, in contrast to trade globalisation, financial globalisation is not ‘democratic’ and is powered more by ‘absolute advantages’ between countries than ‘comparative advantages.’ In other words, financial globalisation has been marked by extraordinary growth in financial activities in established financial markets, rather than in emerging financial markets. This lopsided nature of financial globalisation is consistent with our ‘Global Funnelling Hypothesis’ (see Thoughts on the Global Funnelling Hypothesis, August 31, 2006). · Observation 3. Net cross-border asset positions have deteriorated only ‘slightly’. For the G10 countries, while the total gross asset and liability positions (sum of assets and liabilities) rose from around US$45 trillion in 1999 to around US$103 trillion in 2006, the net asset position deteriorated by ‘only’ US$3 trillion. It is large in absolute terms, but relatively modest compared to the gross positions. The US, Euroland and UK all witnessed deteriorations in their net asset positions, consistent with the thesis that, with financial globalisation, the world had a net demand for assets from these countries. · Observation 4. The need for currency hedging now is more than twice as large as in 1999. With the cross-border investment base having more than doubled, the need for currency hedging should, in theory, also increase commensurately. Further, to the extent that many equity funds have adopted more active currency overlay operations in recent years, the actual increase in demand for currency hedging may have grown even more significantly. Since most of the currency hedging instruments are short term in nature (up to three months), nominal short-term interest rates may, thus, have become more important than real long-term interest rates as drivers of exchange rates. Our currency hedging hypothesis may help explain why the currency markets have acted rather inconsistently with the underlying economic fundamentals and differently from what we learned from Econ 101 regarding how exchange rates should move with real long-term interest rates. One rather disturbing implication is that, if our hypothesis is correct, the influence of cash yield differentials on exchange rates will remain strong permanently, and will not fade unless the underlying cross-border asset holdings decline. Bottom line Currency hedging looks and acts like ‘carry trades’ but is not really the same. The G10 countries’ combined foreign asset and liability exposure rose from US$45 trillion in 1999 to US$103 trillion in 2006. This should translate into a commensurate increase in demand for currency hedging. Since most currency hedging instruments are short term in nature (less than three months in duration), changing short-term interest rates could have a much more powerful effect on the spot exchange rates than in the past and relative to the economic fundamentals.
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ECB Holding It Steady, for Now
September 07, 2007
By Elga Bartsch | London
As widely expected by the market, the ECB left interest rates unchanged at 4% at this week’s Governing Council meeting. In the subsequent press conference, ECB President Jean-Claude Trichet highlighted a rise in uncertainty toward the economic outlook as a result of the recent financial market turbulence, as well as the need to closely monitor all developments, as the reason for the holding operation. However, the Council still views the risk to price stability as being on the upside over the medium term. Judging the monetary policy stance to be on the accommodative side, the Council stands ready to act in a firm and timely manner to ensure that inflation expectations remain solidly anchored. The latter is regarded key by the Council in the context of the current market turbulences. While the ECB still retains a tightening bias, it seems to have adopted a wait-and-see strategy for now. It stressed the need for additional information before further conclusions for monetary policy decisions could be drawn. We therefore deem the chances of another refi rate hike in the coming months to be rather remote and believe that the bank will likely be on hold for the remainder of this year and the early part of next year. The course of further monetary policy action will likely be very data-dependent and likely be driven by the impact of the current financial market turbulence on the inflation outlook. The impact on the real economy and the growth outlook only matters for the ECB to the extent that it is affecting the inflation outlook. Asked whether the ECB would signal another refi rate hike by using the well established code words “strong vigilance”, the president said that he would use those words again if and when they were needed. For now, however, we are back to “monitoring very closely”, which signals a tightening bias, but not an imminent move. The view that the ECB will likely be on hold at least until year-end is backed up by our ECB Refi-Meter. The Refi-Meter, which is a simple statistical model providing an estimate of the probability of an ECB rate hike at one of the upcoming meetings, points to a very subdued chance of a rate hike between now and December. Interestingly, the ECB Refi-Meter also includes inflation expectations, a variable that was highlighted several times by the ECB president as being key for the ECB’s monetary policy decisions going forward. Other variables in the Refi-Meter include M1 money supply growth and bank lending dynamics, which have recently been viewed by the ECB as being more relevant than the broader M3 money supply growth. While the ECB staff projections have not changed materially since June, with GDP growth at 2.5% this year and 2.3% next year, and inflation at 2.0% for both years, we would highlight the downside risks to these estimates, based on the potential repercussions of the US subprime crisis on economic activity in the euro area (see Euroland Economics: How Could the US Disease Infect Europe? August 30, 2007). We have recently mapped out the impact of ongoing equity market corrections and tightening of credit standards and argued that in this worst-case scenario we could see GDP growth being up to 0.5-1 percentage points lower in both the US and EMU, with the main impact being felt over the winter quarters. In this worst-case scenario, we would probably also envisage some ECB refi rate cuts. Currently, a lower refi rate seems to be only an outside scenario. Recent market events will likely also leave their mark on money and credit statistics in the coming months, we think. Note that the ECB will be sure to address any signs of a marked tightening in credit conditions up to and including a soft credit crunch in the context of its two-pillar strategy, and it will swiftly revise its outlook for price stability in the medium-to-longer term accordingly. Hence, a policy blunder as occurred in Japan in the early 1990s remains unlikely in the euro area. To the extent that M1 money supply and bank lending growth will be affected, our ECB Refi-Meter would also be able pick up these signals. The ECB president underlined that the bank is going to pay a great deal of attention to financial market developments in the coming months. In the Q&A session, he emphasised several times that the bank had two responsibilities. The primary responsibility is to ensure price stability over the medium term, and the secondary responsibility is to ensure proper functioning of the money market. The two responsibilities are two separate tasks, according to the ECB, and should not be confused. In order to address to the tensions in the term financing in the money market, the ECB decided to launch another additional longer-term refinancing operation.
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Petrodollar Liquidity Oils the Global Economy
September 07, 2007
By Serhan Cevik | Stockholm
The recycling of petrodollar liquidity has supported the global economy and financial markets. Back in the 1970s, the surge in oil prices pushed the world economy into a deep recession. In the past five years, however, even as the price of crude oil jumped from US$20 a barrel to as high as US$78, nothing really happened to the global economy. In fact, we have witnessed a synchronised acceleration in economic growth across the world. But now the global economy faces a new challenge, emerging from the financial sphere. The abrupt withdrawal of market liquidity — partly created by structured instruments and investor confidence in recent years — has come with financial de-leveraging and an intense credit squeeze. Consequently, for the first time in a long while, with higher borrowing costs and tighter credit conditions, we see more risks for the global economy on the downside. Nevertheless, we do not expect an outright recession (even in the US) and the worst-case scenario for the time being seems to be prolonged uncertainty and below-trend growth. Indeed, if you focus on equity markets instead of disturbing developments in the credit market, you can hardly find a sign of the impending ‘doom and gloom’ for the world economy. In our view, this dichotomy reflects two key factors. First, investors believe that real economic fundamentals are strong enough to withstand occasional bursts of financial volatility. Second, the consensus view is that central banks are in a position to start easing monetary conditions if financial troubles spread into the real economy. But there is yet another channel propping up financial markets as well as economic activity, and that is the recycling of petrodollar liquidity from oil-exporting economies to the rest of the world. Oil-exporting countries have also exported current account surpluses. With higher oil prices, oil-producing countries in the Middle East have enjoyed an unprecedented windfall. Export revenues soared from an average of US$228 billion a year between 1998 and 2002 to US$786 billion in 2006 and, on our estimates, about US$835 billion this year. As a result, the cumulative current account surplus widened from 5.4% of GDP to 20% over this period, creating a sea of petrodollar liquidity that has helped lift all the boats throughout the region and beyond. The rate of real GDP growth accelerated from 3.6% a year in the 1990s to 6.5% in the last five years, and we expect diversification efforts and the existing pipeline of investment projects to keep the expansion phase intact for the foreseeable future. The effects on the rest of the world come through trade and financial channels. First, stronger growth (especially in non-oil sectors) in the Middle East pushes import demand higher, giving a boost to output growth in its trading partners. Second, the recycling of current account surpluses adds to global liquidity and eases the burden of higher oil prices. Indeed, the accumulation of net foreign assets by oil-rich nations increased to an average of 2.1% of global GDP since 2000 and 3.6% this year (see Pumping Money, May 22, 2007). However, although a sudden withdrawal of petrodollar liquidity is unlikely, the amount of recycled surpluses should decline as these countries spend more domestically, and especially if oil prices come down. Oil prices are vulnerable to a slowdown, but we do not expect a deep recession. Structural changes may have moderated the volatility of business cycles and strengthened economic fundamentals, but that does not mean that the global economy is immune to a deep correction in America. In such a scenario, countries with greater exposure to the US and commodity markets would face more downside risks. According to our calculations, the Middle East has become more integrated with the rest of the world — through globalisation and the commodity channel — and consequently more susceptible to a synchronised slowdown in the global economy (see Day and Knight, August 20, 2007). For the time being, Morgan Stanley’s global economics team does not anticipate a recession, but sees slower growth over the next year. Nevertheless, commodity markets are highly cyclical and therefore a global slowdown would lead to lower prices. And this is exactly what we expect. On our estimates, slower demand growth (mostly in the US) will lower the price of crude oil from an average of US$66.7 a barrel this year to US$58.8 in 2008. This could be a meaningful correction, but not dramatic enough to alter the growth cycle in oil-exporting countries or to lead to the withdrawal of petrodollar liquidity.
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Don’t Overreact: Inward Investment Regulations Revised
September 07, 2007
By Takehiro Sato and Naoki Kamiyama | Tokyo
Summary and investment conclusions We see no need for this regulation to be seen as an anti-reform movement. For instance, it would be wrong to assume that the Koizumi Cabinet would not have passed it. Regulations of this type are essentially universal among developed nations, and the new move to specify individual products seems to reflect convergence to international trends to some extent. Investors will now be required to report any holding of more than 10% of a restricted company’s voting rights, after checking for themselves if an investment involves a restricted company. However, there has always been a requirement for direct investments in specific industries to be reported. The revision does not affect restrictions on foreign investment in electricity and the broadcasting industry. The point to note is that these will continue to be applied on an industry basis, while the criteria for manufacturers will be shifted from industries to products, to account for the risk of multi-purpose goods being diverted to military use. Of course, depending on the way this regulation system is managed, it could get in the way of overseas direct investment. We will be monitoring how the authorities manage these regulations ahead. But, according to the METI, there are no past examples of an application being rejected by the authorities; thus, we see no need to overreact in fear of funds’ investment activities being restricted. Answering questions from our investors 1) What’s the background to these regulations?Under the Foreign Instruments and Exchange Law, there has always been a requirement for direct inward investment by foreign investors to be reported in advance, in cases where such an investment may “harm national security, hinder the sustenance of public order, and interfere with preserving public safety”. In areas related to national security, regulations on inward investment are exercised in other developed countries (e.g., the Defense Production Law: Exon-Florio provision in the US, etc.). Japanese regulations do not in any way stand out as being particularly severe. For instance, in the US, foreign investors are restricted from holding more than 10% of a listed company’s stake, just as in Japan. 2) Why now?We think that this revision to the regulations is unrelated to the launch of the second cabinet under PM Abe. In fact, this has been an ongoing project since the Koizumi administration, with the METI taking the lead and incorporating requests from the Japan Federation of Economic Organizations, in a subtle process of preparation. Already, between end-June and end-July this year, the METI had made some public announcements about this, proving that this was no political decision triggered by certain political motivation such as shackling foreign investors. The cabinet decision was made on September 4, and the order is to be issued on September 7 before taking effect on September 28, around when the METI plans to hold briefings throughout the country. 3) In what cases is reporting required?Any acquisition of (or direct inward investment in) 10% or more stake of a listed company included in the restriction list. The regulation states that if a consolidated subsidiary of a restricted company manufactures a product in the list below, the subsidiary is also to be added to the restricted list. 4) What transactions are covered by the restriction?Companies to which the restriction will be applied are manufacturers involved in the production of goods defined in the ministerial ordinance by the METI (Ministerial Ordinance Stipulating Goods and Technology Pursuant to Provisions of the Attachment List No. 1 to Export Control Order and the Attachment to Foreign Exchange Order (Ministry of International Trade and Industry Ordinance, No. 49, 1991). For details, refer to the following website (Japanese text only): http://law.e-gov.go.jp/htmldata/H03/H03F03801000049.html.) As can be seen, the website lists a wide range of items which are highly sensitive multi-purpose products related to the devices of mass destruction and conventional arms. We think that the important factor here is that the new rule lists restricted companies by item and product, not industry, as in the previous regulation. Therefore, investors first need to check whether the listed company they are about to make a direct investment in, or its consolidated subsidiaries, manufactures items included in the list. The METI also states in its public comment that it is fundamentally the responsibility of each foreign investor to judge for him/herself whether a company is covered by the restrictions. That said, when investors have queries, including uncertainties about the interpretation of the law, they may request the METI to confirm their interpretation of the law, as long as the required information (manufactured products, etc) about the investment target is prepared by the investors themselves. 5) What are the reporting requirements?As before, a list must be submitted detailing: (1) investment purpose; (2) investor type; and (3) the businesses that the investing company (including consolidated subsidiaries) is involved in. The paperwork will be processed at the Bank of Japan, which is acting on behalf of the Ministry of Finance as an agent, and the designated forms can be found at the BoJ’s website. 6) What is the reporting/examination period?The METI officially requires a one-month window from reporting until shares can be acquired. According to METI, however, the actual approval answer takes about two weeks. This suggests actually a two-week freeze period, then, between submittal and acquisition. Also, if no stock is purchased within three months from submission, the report must be filed again to newly acquire stock. 7) Has an application been denied in the past?According to the METI, no. 8) How will foreign investors already with a 10% plus stake be handled? Must they both obey the new rules and resubmit entirely? No, they do not need to. However, when investors with a 10% plus equity stake purchase new shares, an application must be filed. 9) Will investment information be protected?METI denies clearly that investment information will become public through the process of applications. Likewise, investment plans of foreign investors will not be opened up to restricted companies. Since applications themselves can be insider information, authorities are nervous about information control, too. Market criticism against all relevant governments Inward investment restrictions (i.e., examination and restriction of share acquisitions) are exercised in the US and the UK for all industries, and against military-related industries and products in France and Germany. But from the perspective of the financial markets, regulations like this to control equity trading and the ratio of stock holding are unreasonable. First, realistically speaking, risks to national security today are not necessarily dependent on the shareholders’ countries of origin. Terrorist groups and antisocial organizations today have a global background; we should consider whether dealing with this sort of issue within a country-based framework has an element of anachronism. We do not think it is appropriate to force a reporting system only to foreign investors, when these regulations are incapable of preventing domestic antisocial and terrorist groups from taking over a chemical plant and producing toxic gases, for instance. Second, the system reduces daily market liquidity and trading opportunities in the related stocks, and deprives shareholders of their opportunities to monitor corporations by exercising their voting rights. We doubt if these costs should be granted from the perspective of national security, and also how effective a measure this really is. Of course, if a malicious foreign or domestic organization tries to acquire shares with the intention of impairing security, the first breakwater should be the board of directors and the general shareholders’ meeting. We can understand the logic behind, for instance, related companies preparing a guideline for defensive measures against hostile takeovers disclosed by the METI’s Corporate Value Study Group, and demanding information on the acquirer; they may regard the acquisition as being potentially destructive to corporate value, if the purpose is to drain technologies or products. However, considerations should be made so as to avoid excessive self-defense by, for example, introducing external directors. In reality, there are even instances of illicit exporting and illicit migration of technology taking place with the consent of companies themselves (not at the hands of antisocial gangs). The essence of security is to intercept outgoing technologies and products at the border and bar the manufacture and use of poisonous gases domestically, not to distinguish between types of shareholder. Restricting stock trading for whatever reason is an inefficiency of a market. Criticism of the Japanese government in the eyes of the stock market That these matters have been debated primarily by METI and the Keidanren without involving investors or the financial administration smacks of weakness and apathy on the part of the FSA. In turn, this brings to mind the weak position of the stock market and its participants in society. While not targeted by this particular revision, in that it should be possible to maintain stable supply and supply of public goods provided business content and oversight methods are established in legislation governing broadcasting business and electricity business, the system of foreigners’ share holdings in the broadcasting and utilities fields based on the Foreign Exchange Law seeks to resolve issues by regulating holders and restricting growth in market enterprise value. As we commented above, security policy that depends on such regulations may not be worth the cost at a time when it is becoming increasingly possible that the danger does not depend on the nationality of the shareholder. In addition, changes in the guidelines for the regulations of mergers in antitrust laws, which cleared up the examination, had only companies in mind, and did not adequately take to heart the views of investors. Although the schedule of advanced consultation is important news in terms of disclosing merger plans, there is no evidence of conforming this with a TOB schedule, etc. In our view, to have policymaking on corporate activity that considers primarily the views of management without adjusting for developments in the stock market represents poor balance by the governing authorities, as well as a weakness of the financial industry, which follows the authorities regulations and supervision blindly without protest. The new regulatory revisions will probably make foreign investors claim bullying toward hedge funds. The September 5 Financial Times article, Japan Attacked Over Foreign Takeovers, carried biting opinions of the Japanese government. Such rules would certainly be a problem if the government was abusing them or was misguided in applying them. The heart of the problem is the government acting without regard to the stock market. A long line of Financial Services Ministers have consistently said they hoped to kick-start the Japanese market, yet investors still think the government moves to hurt stockholders and support businesses. We look forward to improved regulations that are more balanced, that investors can have faith in.
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Don’t Overreact – Effects of Food Price Hikes, Cuts to Mobile Charges on CPI
September 07, 2007
By Takeshi Yamaguchi and Takehiro Sato | Tokyo
There have been increasing moves by foodstuff makers and eating-out establishments to raise prices (September 6 Nikkei Shimbun article). If we make a rough calculation of the effect that these price hikes are likely to have on the CPI, however, we come up with a figure of about +0.1%pt YoY at most. Thus, in spite of the newspaper headline, we believe that the effect on CPI will be insignificant, and the food inflation story seems to be a mere illusion created by the media. Certainly, transaction prices among companies are rising for both goods and services, but at the present time these higher costs are being transferred downstream to finished goods and services extremely slowly, in line with our ultra-conservative price outlook. On the other hand, it has been officially acknowledged that the discount system for mobile phone charges with restrictions attached will not be reflected in the CPI (Ministry of Internal Affairs and Communications material dated August 31), which is likely to diminish extremely bearish outlook for prices, instead. Effect of foodstuff price hikes There has been a series of price hikes for food products such as mayonnaise and by the major coffee chains, but the effect on the CPI has been just about negligible. Regarding mayonnaise, as the media reported, the price index rose by about 10%, but in the case of hamburgers at restaurants, the price index actually fell, even with price hikes by a major hamburger franchise chain in some regions in June. This was because they actually lowered prices of hamburgers in rural areas. The price index for foodstuff overall has not displayed any particular rising trend since the beginning of 2007. Going ahead, the prices of processed foods and food offered by the restaurant industry are likely to rise. Also, a number of sweets makers plan to reduce the content of their products by about 4-11% by October 2007, which will be an effective price hike. Actually, this will be reflected in the statistics as price increases. However, even considering such price hikes, we estimate that the effect on the CPI will be at most about 0.1% YoY. Moreover, in this calculation, we assumed the shares of each product on the high side, assuming that the price hikes would be implemented not only by the companies named in media reports, but also by some competing companies. Thus, the actual effect can be even smaller. Reductions to mobile phone charges The Ministry of Internal Affairs and Communications has made an official announcement that discounted mobile phone charges with conditions attached (this applies to the majority of the current discount systems) will not be reflected in CPI statistics. We pointed out in the past that this was a possibility, so it did not come as a surprise. Nor did it have an effect on our conservative CPI forecast, although it’s likely to weaken the extremely bearish view on prices shared by some extreme market participants on the other hand. However, there is a large price differential between mobile phone calling charges in Japan and abroad, and Japanese mobile phone charges will inevitably decline over the medium-to-long term. Thus, this type of quasi-utility charge will probably continue to hold down growth in CPI. Therefore, on balance, price developments are likely to remain pretty sluggish despite strong desires of policy makers and market participants.
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