28 November 2023: Far too early to discuss rate cuts

Yesterday, Andrew Bailey was scathing in his view of the prospect of the UK finding a path to sustainable low-inflation growth any time soon.

Bailey suggested that the outlook for growth is currently the weakest in his lifetime. The Office for Budget Responsibility also took a swipe at the economy yesterday, suggesting the inflation would be more persistent over the next twelve months than had previously been expected.

Following the Autumn Statement last week, there had been an air of optimism beginning to flow through Westminster, that now looks to have been short-lived.

The Prime Minister, hosting a conference designed to encourage overseas investment in “UK PLC” was far more upbeat in his assessment. Sunak capitalized upon the degree of positivity that the Autumn Statement supplied to suggest that further tax cuts were on the way.

He used typically “Conservative” phrases to underline his view that investors should be allowed to keep more of the return on their capital, since this would make the UK a competitive place in which to invest and promote growth and new jobs.

Bailey’s comments drew criticism from several sources.

However, official data appears to agree with his view. Various reports suggest that growth will be incredibly slow next year, with modest improvement to be seen in 2025.

Although it is outside his remit to involve himself in political debate, he appears to rule out a change of Government being the answer to the country’s woes.

Despite the outlook for the economy, Bailey still believes that it is too early for the MPC to be having a “serious conversation” about rate cuts.

The international community believes that the Bank of England will be the first G7 Central Bank to lower interest rates, having been the first to introduce its cycle of rate hikes in December 2021.

Although inflation has been falling constantly over the past few months due in no small part to lower energy prices, the headline rate is still more than double the Bank’s 2% target and is unlikely to reach that level before 2025 unless there is a significant slowdown in the UK economy.

Despite fuel prices falling to their lowest level this year, Bailey doubts there will be another significant fall in inflation soon to match what was seen last month.

Yesterday, the pound continued its climb towards the seriously congested level which saw it begin its path lower that started in early September.

It reached a high of 1.2644 and closed at 1.2629.

The prospect for monetary policy to remain tight is certainly helping, but there is a more confident feeling in the market that the country will avoid a recession, which looked certain at the start of the second half of the year.

This year is likely to be considered a time of falling inflation, while the economy laid the foundations for sustainable low inflation growth and a more moderate rise in job creation.

Jerome Powell set out his stall at the start of the year by insisting that inflation was his prime consideration, while the market was awash with commentators and analysts insisting that the Fed’s policies would drive the economy into recession by year-end.

The Central Bank managed to halt any prospect of contagion from the collapse of Silicon Valley Bank, which sent ripples through both domestic and international markets and contributed to the collapse of one of the largest, most prominent investment banks, Credit Suisse.

Powell and his regulatory colleagues managed to stem any haemorrhage of capital from regional banks by offering support which, in the end, was not needed even though two other banks were forced to close.

As inflation has fallen and the FOMC has felt able to pause the cycle of interest rate hikes, it has still been faced with a few naysayers who believe that far from heading for a soft-landing the economy is beginning to stall, and a recession still is a distinct possibility.

While two prominent longer-term data streams are still in “inflation territory”, other leading indicators are pointing to higher growth in 2024.

The latest estimate of Q3 GDP that is due for release this week may be revised up from 4.9% to 5% which will supply a significant boost to investors.

Powell and his colleagues have begun to believe that the balance of risks between growth and inflation is roughly equal.

This is a major change from its belief, as recently as the last FOMC meeting, that inflation still posed a threat to the economy.

This view has led economists to believe that a rate cut could take place as soon as the first quarter of next year, although Powell has said on many occasions that rates will remain unchanged for some time to come.

The belief that rates have peaked has led to a correction in the value of the dollar. Yesterday, the index fell to a low of 103.18 and closed at 103.22 and is now close to a level from which it should recover, since it would take a significant shift in overall market sentiment to drive the momentum needed to test the significant level of support around 102.90/103.00.

ECB President, Christine Lagarde, continues to flip-flop between a hawkish view of the Eurozone economy, and a more neutral outlook.

It is almost as if she regrets having pledged that interest rates would remain unchanged until well into the second, or even the start of the third quarter of next year.

With the economy in danger of “falling off a cliff”, there is a real possibility that she will have to put her ego to one side and change her mind.

There is one further tightening measure that the ECB could take, which wouldn’t involve short-term interest rates.

Over the weekend, the Austrian Central Bank Governor advanced his view that the ECB should halt its Pandemic Emergency Purchase Programme, which allows it to provide a backstop to Eurozone Central Banks bond issuance programmes and keeps longer term rates under control.

The first step would be to end the reinvestment of the proceeds of maturing bonds with any new investment discussed on a case-by-case basis.

In comments made yesterday, Lagarde revealed that she is open to a broad discussion with other members of the Governing Council about such a move.

This would advance the cause of tightening monetary policy without dampening demand so radically as a rate hike.

In the wake of the last ECB meeting, Lagarde was asked about the prospect of ending the PEPP early, and she made no comment other than to say that it hadn’t been discussed.

It is now almost certain that PEPP will be high on the agenda of the December meeting.

One of the key elements of controlling inflation is to rein in jobs growth, but leave it at an “acceptable” level.

Lagarde has said recently that there is evidence that jobs growth is beginning to wane and that it will lose momentum by the end of the year.

Since rate hikes take time to work their way through the entire economy, Lagarde would be as well to wait for a month or two to confirm that the hikes that have taken place so far have been fully absorbed.

The Euro continues to make ground against a dollar which remains in a corrective phase. The pace of its rally is clearly slowing and given the proximity of the year-end, traders will begin to scale back positions in preparation.

Yesterday, the common currency climbed to a high of 1.0959 and closed at 1.0956.

The 1.10 level still feels a long way away, and it would take either a confirmation that rate increases have ended in the U.S. or something similarly momentous from the ECB to see it conclusively broken.

Have a great day!