8 May 2024: Pressure is growing for a rate cut

There is growing pressure from several directions on the Bank of England’s Monetary Policy Committee to cut interest rates as soon as tomorrow’s meeting.

The feeling in the city is that a rate cut is now the only way to stimulate activity and growth in the economy, the housing market would undoubtedly benefit from a cut, while the Government needs “good news stories” as it tries to close the “yawning chasm” between it and the Labour Party in opinion polls.

The Labour Party continues to be concerned about any economic improvement providing new impetus to the Conservatives. Keir Starmer and Rachel Reeves have an “inferiority complex” about the economy, a hangover from earlier socialist Governments, which have shown an almost childlike lack of understanding of economic basics.

Reeves is striving to show her credentials as a viable Chancellor of the Exchequer, even soliciting the help of her old boss, former Bank of England Governor, Mark Carney.

Despite the pressure for a cut tomorrow, several economists polled recently were evenly split between June, September and November when asked when, in their opinion, rates would be cut.

The Bank of England does not have the “luxury” that is afforded the Federal Reserve since the UK economy is barely showing any growth, while the U.S. economy is expected to grow between 2% and 2.5% this year.

Labour’s Deputy Leader, Angela Rayner, spends an excessive amount of time criticising the Government’s handling of the economy in general terms, but when put on the spot she is unable to say what Labour would have done differently.

The front page of today’s Financial Times has an article about how the leader of Germany’s Main opposition Party blames Berlin and Brussels for Brexit.

Friedrich Merz, Leader of the centre-right Christian Democrats, stopped short of naming Angela Merkel but believes that the former Chancellor felt that the UK’s presence threatened Germany’s hegemony within the European Union.

If the Labour Party wins the General Election, it may try to agree a closer relationship with Brussels. The Party was unable to agree on its stance on Brexit at the time of the vote, leaving the Conservatives to fulfil the will of the people despite its less than 100% agreement with the decision.

The pound lost ground yesterday as traders returned from the long Bank Holiday weekend. It fell to a low of 1.2500 versus the dollar and closed at 1.2509.

One of the permanent members of the Fed’s rate-setting open market committee believes that a rate hike may be necessary if inflation is going to be finally defeated.

Federal Reserve Governor, Michelle Bowman is well known for her hawkish attitude to rate cuts, but her comments are far removed from the views of her colleagues. Although several FOMC members have made marginally hawkish comments about the need for the first rate cut to be delayed, none have so far raised the possibility of a hike.

Bowman went on to say that while it is not her baseline outlook, she continues to see the risk that at a future meeting, the FOMC may need to increase the policy rate further should progress on inflation stall or even reverse.

Neel Kashkari, the President of the Minneapolis Federal Reserve, commented in an interview that he feels it is not only too early for rates to be cut but also that it is too early to be concerned that the rate of deflation has stalled.

The FOMC needs access to a lot more data to be able to come to that conclusion. He believes that the market was “overly encouraged” by the pace at which inflation fell in the second half of 2023, despite above-average numbers of new jobs being created. Jerome Powell remained cautious about rate cuts at that time and is still rightly cautious today.

Most of last year’s disinflation was seen on the supply side of the economy. Supply chains saw vast improvements, while more workers returned to the jobs market.

Kashkari doesn’t feel that monetary policy affected demand that much and, while he doesn’t believe that another hike will be necessary, the Fed may well be forced to delay any rate cuts until later in the year.

He does not believe an inflation rate of 3% is the “new normal” and a rate of 2% is achievable if the Fed still is consistent in its policies.

Somewhat unfairly, Jerome Powell has the lowest approval rating of any Fed Chairman in the last twenty-five years. High interest rates are irritating consumers as inflation continues to bite. Not having the “charisma” of some of his predecessors counts against him, but he is “getting the job done”.

The dollar index looks to have achieved a short-term bottom, climbing from a low of 104.52, to reach a high of 105.44 yesterday and closing at 105.37.

In the words of Gwyneth Paltrow, the ECB and the Fed are about to consciously decouple. As the Fed looks to possibly leave rates unchanged for the rest of this year, the ECB may well cut rates as soon as next month.

ECB Vice President Luis de Guindos said recently that the Central Bank will have to consider the effect on the exchange rate if it “goes it alone” in cutting rates.

Diverging monetary policy between the ECB and Fed is not a new phenomenon, the Fed began its cycle of rate hikes some months before the ECB, which needed to drain some of the excess liquidity in the market by Quantitative Tightening before raising interest rates.

The dollar index opened at 96.33 in March 2022, the month that the Fed began to hike. It had reached 105.45, by the time the ECB began to hike in July that year.

A single rate cut may not have a significant effect, but the ECB appears to be committed to a series of rate cuts and there is no reason to expect a similar effect this time around as monetary policy diverges.

It took just three months for the ECB to begin to hike rates, it may be close to six months before the Fed matches the ECB if cuts begin next month.

German economic growth has historically been driven by its export-driven growth model. German trade figures showed an increase in exports, even as new orders are still weak.

March exports increased by 0.9% month-on-month, from -2% MoM in February. At the same time, imports increased by 0.3% MoM, from 3.2% MoM in February, widening the trade balance to €22.2bn from €21.4bn in February.

Since the times of German dominance in the fields of heavy industry and luxury vehicles, times have changed, and Germany no longer has the benefit of producing a level of quality that cannot be matched.

Furthermore, geopolitical risks and trade tensions have increased, and Germany barely dominates the EU market currently.

There is no doubt that the EU’s largest economy needs to look closely at its economic model to be able to move away from energy-hungry heavy industry and look more to increase services output, which has been the model adopted by many economies that have been successful in the post-pandemic era.

The Euro is teetering on the cusp of a significant realignment as the ECB grapples with the decision to cut rates.

Yesterday it fell to a low of 1.0747 and closed at 1.0754.

Have a great day!