11 June 2024: Wage increases need to moderate to allow inflation to fall

Wages have been a constant thorn in the side of the Bank of England, even as interest rates have remained at a historically elevated level. Although it was the first G7 Central Bank to begin to hike rates, it has never come to terms with the inflationary effect of wage demands.

UK job growth has been contracting for some time and the trend is expected to continue in May. Job growth is expected to fall by 100 thousand in the three months to April, after a decline of 178 thousand in the previous release.

The weaker labour market will make it easier for the Bank of England to start to lower rates, but wage growth remains high and that is feeding inflation.

Following the pandemic and the consequent rise in inflation, which led Central Banks to embark on a programme of rate increases, job creation has not been an issue as is normally a result of tightening monetary policy.

However, wage demands have consistently exceeded the rate of inflation, creating a wage/price spiral during which one feeds the other.

In the UK, that spiral has not been broken, wage growth is expected to rise to 6.1% in the three months to April, up from 6% a month earlier. Although the overall trend for wages has been down, it is still uncomfortably high for the Band of England.

The markets haven’t fully priced an initial rate cut until November, although a rate cut in either June or August is still possible. Depending on the data.

The performance of Rishi Sunak since he called for a General Election has at least rivalled that of Boris Johnson.

During a televised interview last evening, he continued to insist that a vote for Labour is a vote for a tax increase of two thousand pounds for every working family in the country, despite his assertion that his claim had been verified by Treasury officials, a claim that has been thoroughly discredited.

He was “caught out” using semantics to try to make his point but failed miserably. The BBC’s interviewer opened with the furore over his early departure from last week’s D-Day commemoration, which may well become this campaign’s lasting memory.

He was asked if he had considered resigning but said he still is committed. If the election goes as badly for his Party as is predicted, he may not be given any choice. However, facing at least five years in opposition may make the job a poison chalice for any serious contender for the role.

The pound is still in a relatively narrow range versus the dollar, as monetary policy considerations are now roughly equal between the UK and the U.S. Sterling made up a little ground yesterday, rising to a high of 1.2737 and closing at 1.2730.

Should the Fed be acting preemptively to loosen monetary policy, even though inflation remains elevated to such a level that the market is considering that deflation will never reach its target of 2%?

That question is being asked by the more dovish market participants, who believe that the U.S. economy is on the cusp of a long and damaging period of stagflation.

The answer would be a resounding NO.

No one doubts that a rate cut would cause inflation to “bottom out” at close to its current level of 3.4%. The Fed has made significant strides in lowering inflation from its high of 9.1% in 2022.

Neel Kashkari, the President of the Minneapolis Federal Reserve, commented recently that Americans dislike inflation as much as Europeans, but they hate not having jobs even more.

At the start of every month since the start of the year, most predictions for the level of job creation have erred on the downside and have been constantly thwarted as headline non-farm payroll data has mostly exceeded expectations.

In the inflation report, which is due for release tomorrow, the headline rate is expected to remain unchanged at 3.4% while in last week’s employment report, average earnings rose by 4.1%, a marginal increase over April.

As a rule of thumb, the Fed is unlikely to sanction an easing of monetary policy if wage growth exceeds headline inflation.

The Fed has always had a propensity to shock the markets, but under the Chairmanship of Jerome Powell, those days are now firmly in the past.

Powell would likely self-combust if he had to announce a rate cut to reporters following tomorrow’s and any future FOMC meetings while conditions are still as they are currently.

The current state of the U.S. economy should be labelled “leave well alone”. It has reached “superstar” status, especially within the G7, where if it were a pop star it would be Taylor Swift, or an athlete, peak Usain Bolt.

As the market enters its Summer “lull”, there are no expectations for any change in monetary policy until the Autumn at the earliest, and even then, it would require a significant downward revision in economic considerations.

Following tomorrow’s FOMC meeting, the dot plot, which determines member’s expectations for the first rate cut, may show that there will only be one cut this year, in December.

The dollar index began the new week on a very solid footing, continuing its rally from last week.

It rose to a high of 105.39 but ran into some short-term selling interest and drifted lower to close at 105.12.

If there were a single way to monitor market reaction to a Central Bank’s monetary policy decision, it would be if the Head of that Central Bank feels the need to justify their actions.

Christine Lagarde has given several interviews since she announced last week that the Governing Council of the ECB had voted to cut interest rates by twenty-five basis points.

In some of those interviews, the reasoning behind the cut has not even been the interviewer’s lead question, but Lagarde has still felt the need to justify the decision.

She has tried to temper any further reaction by saying that the gap between rate cuts may well last for several meetings.

The market is now primed to expect the next cut to happen in the Autumn, possibly September or October.

Given the Bank’s overt hawkishness, since it voted to halt its programme of rate hikes, there was still a degree of surprise that the rate cut went ahead since inflation has begun to tick up, even as the level of confidence within the economy seems to have bottomed out.

Emmanuel Macron’s reaction to his party’s poor showing in the elections that were held across the European Union at the weekend was a far greater surprise.

Barely halfway through his second term and will the Euros and the Olympics which Paris is hosting in the coming few weeks, Macron had the perfect opportunity to “tough it out” in the hope/expectation that things will improve economically by the Autumn.

He appears to have backed himself into a corner in his reaction to the far right’s gains over the weekend. Olaf Scholz saw a comparable situation develop in Germany, but he is a more pragmatic politician than Macron, seeing the European Parliamentary elections as similar to how the local council elections are viewed in the UK.

Campaigning will be difficult with the Euros distracting many voters. The vote will be in two rounds, on June 30th and July 7th, just three weeks before the Olympics.

The Euro broke through its medium-term level of support yesterday, falling to a low of 1.0732, but it rallied to close at 1.0765 as the reaction to the gains made by the far right across the entire Union was put into perspective.

Have a great day!