28 March 2023: BoE sees UK banks as resilient

At last week’s meeting of the Bank of England’s Monetary Policy Committee, there was a significant shift in the Bank’s view of inflation. While they still hiked interest rates, for the eleventh consecutive time, to 4.25%, the highest they have been in fourteen years, there was a lowering of expectations for inflation that will be reflected in its Quarterly Economic review that will be published later today.

While in the recent past the bank has hoped that inflation will be falling by Autumn, members of the MPC now believe that it will have fallen to close to its target of 2% by the end of the third quarter.

Interest rates are expected to peak at 4.50% with a hike at the next meeting due to be held on May 11th expected to be the last in the current cycle.

It remains to be seen whether Andrew Bailey will announce this as a policy change, or whether he will remain cautious by continuing to say that the committee is driven by the data.

Committee members have for several meetings expressed their individual reasons for why they voted as they have. The most definitive views have been provided by the independent members. There was a danger that Catherine Mann, Silvana Tenreyro, and Swati Dhingra were going to use the MPC as an exercise in economic theory, since the fourth independent member, Jonathan Haskell tends to be seen as in step with the Bank of England’s in-house views.

There has been a significant upgrade in the market’s view of GDP growth for this year. Where earlier in the year, the economy was expected to contract by around 1%, growth of anything up to 0.5% is now seen as achievable.

With the economy still experiencing a drag of around 4% in total from the effects of Brexit, any growth this year will be an achievement. The effect of Brexit is expected to fade gradually over time, but analysts believe that it will be at least five years until it will be seen as a positive.

In a speech yesterday, Andrew Bailey of the subtle changes in the economy that have occurred since the Pandemic. The most obvious has been the change in attitude to work.

There has been a surge in the number of skilled workers in both the services and manufacturing sectors who have decided to take early retirement, considering a more leisurely work/life balance. Foreign workers who have departed following Brexit were mostly unskilled, but there is now a significant shortage in skills that is affecting productivity.

Bailey went on to say that the UK financial sector remains robust, with supervision playing a major role. He doesn’t expect to face any pressure on monetary policy from liquidity needs, and this has been interpreted as a signal that rates won’t need to be cut this year.

The pound had a solid start to the week, rising to a high of 1.2293 versus the dollar and erasing its losses from Friday, It eventually closed at 1.2286.

Against the Euro, it has seen renewed strength, reaching a high of 1.1396 yesterday and closing at 1.1378.

There have been discussions going on about the prospects of the Federal Reserve being able to manufacture a soft landing for the economy during its current cycle of tighter monetary policy. Over the first quarter of this year, it has gradually been accepted that the Central Bank would be able to lower demand without driving the economy into recession.

At the start of the year, the odds of a recession were up at around 60%, but they have gradually fallen to around 30%.

However, that was before the current liquidity crisis began, which has seen two banks fall into administration with up to $125 billion withdrawn from regional banks and placed in what are considered the safer havens of larger, more heavily capitalized banks.

Investors are a wait and see policy to the U.S. financial system currently, well aware that there may still be some issues lurking, while it is by no means certain that there is sufficient liquidity in the system without the Fed and Treasury having to intervene.

Treasury Secretary, Janet Yellen, and Fed Chairman Jerome Powell have both embarked on separate tours, speaking of their confidence in the banking and wider financial systems, although on the robustness of the economy they speak with a single voice.

Yellen continues to repel calls for the Administration to pledge to insure all deposits with U.S. banks, not just those of less than $250k, while Powell doesn’t envisage a situation where the Fed may be forced into an emergency rate cut to encourage liquidity.

The March employment report will be published next week, and although several commentators have been chastened by their constant underachievement in forecasting the data accurately, many are still looking for the watershed moment when the Feds tightening of monetary policy will have an effect.

What the market fails to consider is just how low interest rates were at the start of the process and how far they have had to travel to reach equilibrium where they are neither restricting nor promoting demand.

It may very well be that rates are now approaching a neutral state but given that the most common view is that the Fed will be one (more) and done ate its next meeting the market may soon be experiencing a whole new paradigm

The dollar is being driven by two alternating factors currently. The first is the likelihood that the Fed is about to call a halt to its programme of rate hikes, while there is still risk aversion which drives buyers of the dollar.

Yesterday, the dollar index fell marginally to a low of 102.84, closing at that level.

While having to provide verbal support for Germany’s largest bank, the ECB President and several other major figures from the Eurozone are still also promoting the notion of further rate increases.

Christine Lagarde, together with The Bundesbank President and German Chancellor, are showing significant confidence that the financial system in general and Deutsche Bank in particular are robust. They are, however, hedging their bets by also saying that they are prepared to flood the system should there be any need.

The expected continuation of rate increases by the ECB has contributed to lower expectations for growth in the region. While a few members of the Eurozone are going to experience recessions, the overall expectation for the region is that its economy will grow by 1% with GDP remaining pressured until the second quarter of 2025.

A lot depends on how much more rates will need to rise in order for inflation to fall to the ECB’s target of around 2%.

It is more than a little ironic in light of inflation still being above 8% that there was a major furore when the Central Bank revised its target to an average of 2% rather than 2% flat.

The more hawkish Central Banks remain committed to driving inflation lower by tightening monetary policy even further. With interest rates having been at historical low rates and the ECB never having faced continuing high inflation, it faces a similar issue to the Federal Reserve in that it is unsure how much further rates will need to rise in order to restrict demand.

It seems that the Governing Council of the ECB is prepared to virtually write off 2023 since there are many problems that face it that monetary policy alone will be unable to remedy. The war in Ukraine is the most obvious, with an escalation by way of a Spring offensive expected to begin at any time.

The euro recouped some of its fall from last week yesterday. It rose to a high of 1.0800 and closed at 1.0497.

Have a great day!