16 May 2024: The economy is still giving mixed signals

It is becoming ever more difficult to judge when the Monetary Policy Committee will feel sufficiently comfortable with the path lower for inflation to consider cutting interest rates.

Andrew Bailey has provided as much advance guidance as he can, but the economy keeps throwing up further reasons for delaying rate cuts.

The surprise news that the economy grew by 0.6% between January and March provided the MPC with more “wiggle room” since it became evident that not only did the country exit the recession it had dipped into in the second half of 2023, but it did so in spectacular fashion.

The two dissenting members of the MPC who voted for rates to be cut at its most recent meeting, Swati Dhingra and David Ramsden, had voted for a cut based on their view that the level of interest rates was driving the country further into recession.

It will be interesting to note if these two have been convinced that interest rates are currently at the right level to combat inflation when the Committee next meets on June 20th.

Following the surprise growth data, the April employment report delivered further contradictory data earlier this week.

The unemployment rate is beginning to rise, and although it is nowhere near the level that will concern the more dovish members of the MPC, average earnings are still at a level which needs to fall for the hawks on the Committee even to consider a cut in interest rates.

Overall, the rate of inflation remains high even considering that Bailey has said that it doesn’t need to have reached the 2% target for rate cuts to begin, as long as it is showing evidence that it is on a clear path in that direction.

All G7 nations are seeing similar situations where inflation fell at a “healthy” pace until February, but as their economies adjusted to the level of interest rates it became more “sticky”.

It may well be that the Fed, ECB, and the Bank of England will need to consider their confidence that inflation will eventually fall to its 2% target and accept that in the new post-pandemic world the current level of interest rates is not conducive with inflation at 2%.

Huw Pill continued his “wait and see rhetoric” when discussing the rate of deflation earlier this week, but he may need to “get real” at some point and along with his colleagues at both the MPC and other G7 Central Banks accept that they are “chasing rainbows.”

The pound rallied to a high of 1.2687 yesterday as weak retail sales data and falling inflation in the U.S. brought a rate cut back to the table.

It closed just one pip from its high at 1.2686.

Just as the market was growing used to the possibility that interest rates won’t be cut this year, the economy has pivoted again and is showing signs of a slowdown.

The consumer had been the most noticeable area of the economy that had continued to thwart the elevated level of interest rates designed to bring demand down and with it inflation. However, data from the first quarter of this year showed that consumer confidence had remained high.

However, since the start of last month, there has been anecdotal evidence that consumers are suffering a delayed reaction to the level of interest rates, while inflation is now considered an obstacle since its fall appears to have stalled.

Retail sales were flat in April, down from a 0.6% gain in March, while headline inflation fell to 3.4% from 3.5% last month. The core rate of inflation also fell, to 3.6% from 3.8%.

Loretta Mester, the President of the Cleveland Federal Reserve, and one of the more dovish members of the FOMC, spoke earlier this week of her confidence that rates would be lowered this year, but since rates are close to what she considers “neutral” the FOMC can “take its time.”

It does appear that the economy is now at an inflexion point where activity is slowing, but not alarmingly so, and it may well be that the Fed Funds rate has reached a level where the balance of risks between growth and inflation is roughly equal.

Monetary policy is such a “blunt tool” that it is impossible to fine-tune the balance of risks any more than has been seen over the past thirty months.

Federal Reserve Vice Chairman Philip Jefferson echoed Mester’s words by commenting that ‘rates should be held steady until the rate of inflation is ebbing’.

The more hawkish case has been made by, among others, Neel Kashkari from Minneapolis, who commented yesterday that he is concentrating on the housing market currently.

He has been surprised at how resilient the property market has been over the past six months, which questions how restrictive monetary policy is.

The dollar index is far more affected by the prospect of a rate cut than other G7 currencies. The weaker-than-expected data published yesterday drove the index down to a level not seen since mid-April.

It fell to a low of 104.29 and it closed at 104.30.

The ECB has little concern for the effect changes in monetary policy will have on the single currency.

In the past, Central Banks have been most concerned by volatility, which brings with it instability.

When it appeared that G7 Central Banks were moving roughly in tandem, traders were content to see currencies in narrow ranges. However, over the past six weeks, there has been significant divergence between the dollar, on one side and the Euro and Sterling, on the other.

This led to these currencies making lows for the year of 1.0598 and 1.2300, respectively. Now, as the U.S., economy has shown nascent signs of beginning to slow down, traders are concerned that the Fed will act more proactively than either the ECB or the Bank of England and begin to cut rates sooner.

Both the Fed and the ECB have explicitly stated that they will only seriously consider rate cuts when inflation has reached 2%.

In the case of the ECB, that now seems eminently achievable since the headline rate of inflation for April published earlier this week saw price increase reach 2.4%, even though it was unchanged from March.

The headline rate of inflation in the U.S. is significantly higher, but the Fed will be sufficiently concerned about a slowdown in the U.S. economy to consider cutting rates significantly earlier than its November meeting, which is considered the favourite currently.

There have been some members of the ECB’s Governing Council who have voiced concerns about a decoupling of monetary policy between the Eurozone and the U.S., with the common view being that if the Fed delays its first cut, the Euro will suffer.

However, the Fed’s proactivity may dictate the possibility that they may become coupled again.

After a period of calm in the market, there is a genuine possibility that volatility may return before the summer lull kicks in, with Central Banks facing renewed pressure to make the “right” decisions.

The Euro rallied to a high of 1.0886 yesterday and may test the resistance at 1.0920. It closed at 1.0884.

Have a great day!