30 January 2023: How long until rates have to be cut?

Andrew Bailey, the Governor of the Bank of England, believes that flexibility is the most important feature of monetary policy going forward.

The Monetary Policy Committee is due to announce the latest change in short term interest rates on Thursday following its meeting this week. While observers expect there to be a further hike of fifty basis points, they also expect the end to the current cycle of hikes to end quite soon, possibly by the end of the currency quarter.

Bailey is on record as saying that he doesn’t expect rates to begin to fall until the fourth quarter, but he has commented recently that he believes that the Bank needs to be more flexible on policy and look at ways in which the level of demand can be altered in the short term.

Having begun a programme of interest rates rises over a year ago when they were at historic lows, they have taken an inordinate amount of time to reach a level where they are beginning to restrict activity.

In the Governor’s opinion, this is far too long a time while inflation was rising exponentially. One answer would have been to increase the increments of the increase, but there was concern that given the precarious state of the economy at the time, that it could easily have led to a deeply damaging recession.

Bailey has become more optimistic since the last monetary policy report was delivered in October and although the next report that will be published on Thursday won’t contain a timetable for the taper of rate hikes, it may contain some hints as to the Bank’s thinking.

This is potentially a watershed week, with several G7 Central Banks meeting to discuss monetary policy.

Since the Pandemic, a degree of unity has seen interest rates rise globally to counter the level of inflation. The comparison of just how hawkish or dovish each Bank is is as important to traders as the actual size of the hike.

With the Fed, and ECB meeting this week, as well as the Bank of England, Sterling may see increased volatility and wider daily ranges than have been seen recently.

Last week, the pound finished marginally lower, but its trading range was quite narrow. It reached a low of 1.2263 but recovered to close at 1.2390 just ten points lower of the week.

Jerome Powell’s second term as Chairman of the Federal Reserve has been far more challenging than his first. His second term only began in May of last year, but he has had to deal with inflation that had risen almost out of control since then.

He is something of a novice Central Banker but has been suitably forthright in ensuring that the market receives what he believes to be the right amount of advance guidance concerning future Fed actions while defending those actions to a market which can be fickle in its attitude towards the Central Bank.

It is a fact of life that any Chairman who presides over a period of rising interest rates will be unpopular, but Powell’s arguments for higher interest rates have been delivered both sympathetically and with some feeling for their effect on the market.

When delivering jumbo rate hikes of seventy-five basis points last autumn, he has tried to show how they are necessary and while he remains hawkish, he listens attentively to the comments of both the Fed Governors but also the Regional Fed Presidents who make up the FOMC.

This week, the FOMC will confirm another rate hike. The Market is unsure if it will be twenty-five or fifty basis points. Powell favours fifty as he wants to stay the course to defeat inflation, while there have been calls from the regions that they support a less severe hike of twenty-five points.

The FOMC will have an advance cut of the January employment report available to them. In its continued desire to be data driven, the Committee may provide the market with some advance guidance regarding the data.

The first predictions point to new job creation having fallen significantly to between 150k and 175k, although wage growth may have moderated.

Any sign that the FOMC is considering either a lower rate of increase in rates or a pause entirely will see the dollar index come under pressure.

Last week, it managed to remain above the support at 101.20 in quite this trading. It reached a high of 102.43 and closed at 101.95. The degree of support that the dollar is gaining from hawkish monetary policy is beginning to fade as the ECB, in particular, is seen to have a far longer path to travel until it reaches a similar to where the Fed finds itself now.

Christine Lagarde, the ECB President, has had quite a full calendar over the past three months and that situation is unlikely to change in the short term.

As the Governing Council continues to vote to increase interest rates, it increases the pressure from the more indebted nations for hikes to come to an end.

As inflation begins to fall moderately, both the hawks and doves are potentially disappointed and the pressure on Lagarde increases and the decision becomes harder to justify.

A vote to hike by fifty points at this week’s meeting will disappoint the hawks, who believe that a seventy-five basis point hike will bring rates to a restrictive level faster and significantly dampen demand. It will also draw criticism from the Doves, like Italy, who believe that if rates are to rise at all, and they seriously doubt that is the case, then twenty-five basis points is sufficient.

They point to the UK, where the Bank of England has been hiking in small increments for more than a year and are having a positive effect on inflation without falling (yet) into a recession.

The euro is beginning to find its feet after a turbulent six months in which it fell below parity to the dollar. The period that it was worth less than a dollar was relatively short, and it has recovered since, which should have had a positive effect on inflation.

That in itself is a double-edged sword. The comparative level of interest rates affects the currency. This has been an advantage for the dollar since the Fed was considered to be by far the most hawkish Central Bank in the G7, driving the dollar index to historic highs.

Now, that mantle has been handed to the ECB with the euro expected to test the 1.10 level, possibly this week.

Last week, the resistance at 1.0930 was tested but the single currency had insufficient momentum in a quiet pre-central bank meeting week to sustain a mover higher.

It rose to a high of 1.0925, but fell back to close at 1.0865.

Have a great day!