26 January 2023: Bailey predicts rapid fall in inflation

In spite of a continuing cost of living crisis, rising interest rates and industrial action across the public sector, Andrew Bailey the Governor of the Bank of England is optimistic that the contraction in the economy, which may have already started, will not be the devastating recession that he feared when he gave his last update on the economy last Autumn.

Although economic forecasts are based on more than gut feelings, and Bailey doesn’t command the level of respect in the markets commanded by some of his predecessors, he is confident that inflation which remains at the root of the country’s issues and is still in double figures despite a tightening of monetary policy which has lasted over a year, is about fall rapidly.

Scarcity of workers brought about by Brexit and the unwillingness of workers to do the same jobs for the same money following the Pandemic as well as pent-up consumer demand meant that prices rose at a rate not seen in a generation.

Throw into the mix an energy crisis and the war in Ukraine and you have all the ingredients for a rapid decline in the economy.

One of the reasons for Baileys optimism is the fact that significantly lower energy prices, have fed through into official day yet, will lead to lower inflation.

The most significant feature of the current crisis has not been the gradual decline of the economy, as has been seen in other recessions, but a series of shocks which while tough to recover from are more easily dealt with than a structural decline.

Have no doubt that this Government has provided several of the issues by its penchant for ignoring its own rules. Lockdown didn’t seem to apply to Johnson’s Cabinet, while having a Chancellor of the Exchequer who is accused of avoiding tax and paying a fine levied by the tax authorities is not a good look.

What followed was the election of a naive and inexperienced Thatcher clone who was determined to do things her way. She quickly found that an inability to carry the Party with her was a fatal flaw.

The wholesale price of gas has fallen by 60% from its peak last August, and while Allie’s recent increase in support for Ukraine may bring a stinging round of retaliation from Russia which has no problem in weaponizing every advantage it can, overall the shocks that have brought about both a theoretical downturn and genuine concern over a deep and long-lasting recession are solvable in the medium term.

The UK and Eurozone have been forced to curb their reliance on Russian energy, which they should have been working on despite Vladimir Putin demonstrating his own brand of hegemony, but while there was a degree of cooperation on both sides, both were happy to allow the status quo to exist.

The UK is still a long way from stable growth and low inflation, in truth neither may be seen before the next General Election, but every long journey starts with a single step.

Yesterday, the pound rallied to a high of 1.2400 and closed at 1.2397 as traders saw no reason for the Central Bank to taper interest rate hikes, which it feels will continue for at least the remainder of the first quarter.

The ascent of Lael Brainard to the top of American Financial and Economic leadership appears to have no bounds. Already seemingly a Chairperson of the Federal Reserve in waiting, she is expected to be nominated by President Biden to the Presidency of the White House National Economic Council.

This means she will be at the forefront of Administration Policy and arguably will have more influence than either Jerome Powell or Treasury Secretary, Janet Yellen.

The Financial Press considers Brainard a shoo-in for the post which she will take over as the country is seemingly headed for a recession.

Jerome Powell is of the opinion that even if the economy falls into a recession, which he may have to take at least some responsibility for, it will be both shallow and short-lived.

The Fed Chairman has been considering what actually constitutes a recession, as the accepted two quarters of contraction is a European invention and not every recession can be characterized in this manner.

The most recent recession, which was due to the Pandemic, only lasted for one quarter but was among the deepest in history.

Brainard sees her belief in strong regulatory authority but less severe monetary policy, which sets her at odds with several colleagues on the FOMC, as being her major strengths. She is also at the forefront of a scheme which provides federal guarantees for low income earners to borrow, despite not necessarily enjoying the most stable of credit ratings.

There is still a degree of confusion and indecision over whether the economy will fall into recession this year. The traditionalists see the continued tightening of monetary policy as a leading indicator of a slowdown, even if the strength of the employment market is a significant factor driving those who see the possibility of a soft landing being engineered by the Central Bank.

Next week’s FOMC meeting is expected to agree to a hike of twenty-five basis points which will likely be repeated at the next two meetings which will bring short-term rates to 5% which is the Fed’s assumed target.

Once that has been achieved, the FOMC will feel justified in pausing to take stock.

The preliminary read for fourth quarter GDP will be published. It is expected to show that the economy grew by 2.6% between October and December, Down from 3.2% in the third quarter. This was supposed to be the quarter in which the slowdown began, but so far there is little sign of that.

The dollar index broke lower in its distinct but spluttering march lower in response to market fears of a recession and the end of tighter monetary policy this quarter.

It fell to a low of 101.56 and closed at 101.63. The close below the 101.80 is potentially significant, as it may open up a test of the stronger support at 101.30.

When the economic outlook is at its darkest, that is often the point when looking back, economists and market commentators often believe, is when the recovery begins.

That much appears to be coming true for the Eurozone economy, although it still has the potential for several missteps.

The most critical of those is the timing of the pause in tighter monetary policy.

The end of higher short-term rates is at least three or possibly four meetings away, as the hawkish members of the governing council appear to have wind in their sails, as well as the explicit support of the President of the Central Bank.

Next week’s meeting of the rate-setting committee is likely to agree to a hike of fifty basis points. since it remains fearful of the effect of a jumbo seventy-five basis point increase which the Frugal Five believe is warranted, but the more dovish nations feel it will add further momentum that will be hard to stop.

The Italians are without doubt the most concerned about the length of time that rates will continue to rise, as it brings them ever closer to another debt crisis. The most recent official data for their debt to GDP ratio is three years out of date but was already at almost 135%, while the budget deficit is standing at between 4.5% and 4.9% of GDP.

Although Brussels has turned a blind eye to its Growth and Stability Pact since the emergence of the Pandemic during which, Italy was the first and arguable the European Union’s hardest hit nation, at some point it will expect it to begin to make improvements, which will become ever harder to do given the parlous state of its National Balance Sheet.

The agreement of Germany to authorize use of its Leopard Two Battle Tanks in the war in Ukraine means that there is a real possibility that Germany will face repercussions in the shape of reprisals from Russia.

Germany was initially loath to be the only nation seen to be providing a second wave of support for Ukraine, but with the UK and U.S. also agreeing to send extra equipment, the unity of the Allies was considered to be the overarching reason.

The Euro maintained its steady rise yesterday as the dollar index again faltered. It rose to a high of 1.0927 and closed at 1.0914. The break of the 1.09 level brings into view 1.10, but there is some strong resistance to be breached before a test of the level is tried.

Have a great day!