16 January 2023: Inflation may have peaked

The data for GDP that was released late last week confounded markets that had seen very little cause for redemption for the UK economy following a year that was characterized by negativity at just about every turn.

Political upheaval, industrial action, inflation and Brexit each conspired to provide an expectation of weakness and recession for the economy. However, there was one bright spark in the final quarter of the year, provided by the FIFA Men’s World Cup, which took place in Qatar.

While the performance of the England team was fairly predictable, the tournament gave a healthy boost to the economy and allowed it to show a surprising level of growth and activity at a time of year that often disappoints.

The UK economy grew by 0.1% in October, boosted by significant activity in the hospitality sector and video game sales. It had been expected to contract by 0.2%.

While the country is far from out of the woods yet, the data reduces the chance that a recession has already arrived in the final quarter of the year. The surprising level of growth seen in December means that the economy will need to have shrunk by 0.5% to record a technical recession, in which the economy contracts for two consecutive quarters.

It may be that the widespread industrial action which took place in December has led to such a fall, but overall the picture remains subdued.

This week will be an important one for the economy, with both employment and inflation data due for release. Tomorrow’s employment report for December is expected to show that the headline claimant count rose by around 35k and the employment rate perhaps touching 4%.

The rate of inflation is expected to have moderated in December, falling from 10.7% to 10.6%.

Given the fact that the Bank of England continues to hike rates, bringing them well into what is expected to be restrictive territory, it is surprising that the headline rate is not beginning to fall more quickly.

The pound is not attracting much support, but given a bout of dollar weakness that is prevailing, it has risen during the first two weeks of the New Year almost by default.

Last week it rose marginally, making a high of 1.2248. It closed at 1.2234. Given the amount of tier one data due for release this week, it is likely that volatility will increase.

The discussion regarding the chances of a recession taking place in the U.S. this year continues, with each side as certain as the other about the trajectory of the economy, particularly during the first half of 2023.

The no recession side has been buoyed by the pace at which new jobs are still being created, despite the Federal Reserve hiking rates at every meeting since last Spring.

However, those who believe that a recession is most likely to start in the second quarter point to the very fact that rates continue to rise as the reason why demand will be choked off and unemployment will begin to rise.

Time is beginning to run out for rate increases to have a negative effect as the Fed may have struck the right balance, more by luck than judgement, given that rate increases didn’t turn the outlook negative for several months after they began.

Jerome Powell, the Chairman of the Federal Reserve, appears to be agnostic over the effect of rate increases on the economy, refusing to be drawn on the subject as inflation, not growth, is his primary mandate.

There have been plenty of comments made in the past few weeks, mostly coming from the more hawkish members of the FOMC. The most popular view appears to be that the Central Bank will pause its cycle of rate hikes soon, but is not willing to do this experimentally.

Hike will only pause when the FOMC believes that inflation won’t return. They would not want to pause only to be forced into hiking again subsequently.

This week, the Empire State manufacturing index will be published. This is expected to show a healthy recovery, although it will remain in negative territory.

Producer prices and retail sales are due for release on Wednesday. Producer prices are likely to continue the moderate fall we have seen in recent months, while retail sales are expected to have reversed the negative result seen in November and gone from -0.6% to +0.1% in December.

The dollar is struggling to do anything else other than continue to test medium term support. The market believed that the Fed will taper rate hikes before either the ECB or BoE and this is deterring traders from providing support.

Last week, the dollar index fell to a low of 101.99 and closed at 102.17.

Christine Lagarde has been subtle in her change of tack from being overtly dovish on interest rates to being mildly hawkish.

Is the two sides of the whole debate on the level of short term interest rates are to be believed, the Central bank is damned if they continue to pursue a course of higher short term rates and equally damned if they don’t.

The hawks, made up of the Frugal Five, see inflation as the most serious affliction that can affect the economy and believe that the ECB maintained interest rates at an artificially low level for at least a quarter too long, which allowed inflation to become ingrained.

They see rising rates as necessary for rising prices to be tackled, and they also believe that this will encourage savers and pensioners who have not been receiving a fair return on their deposits.

It has been proven, especially in the case of Germany, that raising rates in moderate increments is no impediment to growth. Germany, having struggled economically for most of 2022, is now expected to avoid a recession since its economy grew by 1.8% last year.

There is still some concern that it will contract by 0.3% in 2023, but that is now considered unlikely given its recovery in Q4.

The doves, made up of Italy and increasingly Portugal, believe that their economies are being harmed by higher interest rates as they each continue to struggle with their debt burden, which in the case of Italy, is now causing serious concerns in financial markets.

Portugal has openly demanded that the ECB provide it with financial support, but so far they have been denied by Ms Lagarde. Firstly she sees support as likely adding to inflationary pressure while she holds up Greece as an example of what can be achieved by a heavily indebted nation if it adopts strict financial discipline.

Politically, neither Italy nor Portugal is willing to adopt Greek style policies, given the fragility of their respective Governments.

This week, there is a Eurogroup meeting starting today in which the finance ministers of Eurozone nations will try to find some commonality. Tomorrow, Germany will publish inflation data for December, while the ZEW institute will release its economic bulletin for the country.

On Wednesday, harmonized inflation data will be released. This is expected to be unchanged, galvanizing the hawks to demand larger rate hikes.

The euro is garnering support in its own right as well as from a period of dollar weakness, last week it rose to a high of 1.0868 and closed at 1.0832. It seems likely that it will challenge the 1.10 level in the next few days/weeks.

Have a great day!