20 January 2023: New pay deal offered to rail workers

The Governor of the Bank of England, speaking on a visit to South Wales, spoke yesterday of his belief that inflation will have fallen significantly from the Spring, although he feels that the continued tightness of the labour market will lead to the Central bank needing to continue to hike the base rate which currently stands at 3.5%.

He refused to speculate on where rates will be when the Bank feels confident to pause the current cycle of interest rates rises.

The feeling in the financial markets is that rates will reach at least 4.5% before the bank ends the current phase. As in the U.S. and the Eurozone, rates have been at historically low levels for a considerable time, and this means that finding the neutral level may be difficult.

There is no scientific method of predicting when rates have reached a point where they are no longer accommodative. However, a combination of falling inflation and rising unemployment, coupled with a downturn in economic activity, will guide the Bank.

Bailey went on to say that he expects the economy to suffer a recession from the current quarter. He feels that it will be shallower than on previous occasions, but will last longer than is what is considered normal.

The Bank of England has had a tightening bias for well over a year, but the size of increments of the increases have been questioned given the length of time it is taking for rates to reach neutral.

Bailey feels that it has been a tough balancing act to try to reduce inflation yet not drive the economy into recession.

Given the generally more supportive view of the IMF and World Bank regarding the global economy since the end of the third quarter, a shallow recession is probably the best the UK can hope for.

Bailey praised the independent members of the MPC for their unique perspective on the economy. Catherine Mann and Silvana Tenreyro, two of the three independent members, sit at opposite ends of the rate hike spectrum.

Mann voted for a super-sized seventy-five basis point hike at the last MPC meeting, while Tenreyro voted for a smaller hike than was finally agreed.

The pound has yet to really show a trend since the start of the year. The outlook for interest rates has been a relatively supportive factor. Speculation about when G7 Central Banks will begin to taper hikes will be a driver for at least the first two quarters.

Yesterday, the pound gained a little ground against the dollar, reaching 1.2397 and closing at 1.2387. 1.2420 appears to be resistance, and it will likely find it hard going to break that level given its relative lack of momentum.

The data for weekly jobless claims has been in a 180k/220k range for the past year as the employment market has confounded a continuing series of interest rate hikes by the Federal Reserve. The same is true regarding job creation, which remains at the upper end of expectations.

For at least the past quarter and possibly longer, the market has been predicting that the headline non-farm payroll data would see some reaction to the rate hikes, but so far the effect has been negligible.

The FOMC remains driven by data, which makes it far more reactive than has been the case under the previous Chairmen.

Under both Alan Greenspan and Ben Bernanke, the FOMC was largely a rubber stamp to their view of the economy. The previous Chairperson, Janet Yellen, ushered in a far more technocratic era, while Jerome Powell, in typical lawyer’s style, wants to hear as many views as he is able before deciding his opinion.

This would normally lead to a degree of unpredictability, but since his rather rash comment about inflation being transitory, quite soon after he had taken office, he has been open to repairing the damage that his remarks caused, since he was taught a rather salutary lesson on how his remarks are likely to be viewed.

Recent output data has pointed to a weakening economy, although the Philly Fed Manufacturing data which was released this week showed a marked improvement, despite remaining in negative territory.

Industrial Production and Capacity Utilization remain weak, while retail sales fell for the third month in a row.

Traders are yet to decide when the Fed will begin to taper the size of interest rate rises again. Having moved from seventy-five basis points to fifty at their last meeting, comments from a number of FOMC members since that meeting show a preference to remain at fifty.

The dollar index is following the path of interest rate expectations. Yesterday it fell to 101.98 and closed at 102.07. There is a significant band of support between 101.80 and 102.20 which the index appears unable to break in either direction. Unless there is a major announcement from Powell, or some other significant driver, it is unlikely to move too far away from the current level until the FOMC meets on February 1st.

ECB President Christine Lagarde spoke yesterday about the Eurozone economy and her belief that 2023 will mark a significant recovery.

In particular, the second half of the year will see the region stage a comeback, since she believes that to a large degree market expectations have been driven by a degree of negativity which isn’t based on reality.

Several Eurozone banks have published commentary recently in which they believe that although interest rate policy is a significant driver for the single currency, it is the end of the energy crisis that is holding it back and once the wholesale price of gas begins to moderate the economy should begin to flourish.

That having been said, it is likely that as the energy price comes back closer to historical levels, inflation will fall and the pressure for further rate increases will diminish.

Ms Lagarde does not expect this to happen until the second quarter, as she poured cold water on those who feel that the Central Bank is close to ending its cycle of interest rate hikes, or at least tapering the size of the increments.

Lagarde’s comments were backed up by Klaas Knot, the Head of the Dutch Central Bank, also commenting that he believes that several fifty point hikes are still necessary to bring inflation lower.

It is certain that the battle between the hawks and doves has been won by the doves, and rates are going to continue to rise.

The best that can be expected for the weaker economies is that the higher interest rates can be somehow be offset by some form of support from the ECB to help them cope with falling bond prices leading to higher long-term rates.

The euro, in company with other major currencies, remains under the spell of the various Central Banks as traders continue to see interest rate differentials as the only game in town currently.

The single currency gained yesterday on the back of the relatively hawkish comments from Lagarde and Knot. It rose to a high of 1.0840 and closed at 1.0829.

Have a great day!