12 June 2023: BoE under threat from Labour Government

The political landscape in the UK incontrovertibly changed at the end of last week as former Prime Minister, Boris Johnson, resigned in the wake of the publication of the report into “Partygate” which he labelled little more than a “witch-hunt”.

There were further departures confirmed by some of his supporters while Johnson himself hinted that he would be back, possibly standing for the seat vacated by former minister Nadine Dorries.

Prime Minister Rishi Sunak returned from his trip to Washington, having made little progress over a free-trade agreement with the U.S. which is now unlikely to happen before elections take place on both sides of the Atlantic.

Sunak now faces three by-elections, two of which will be held in constituencies that can hardly be called safe.

While staying well ahead in opinion polls, Labour will also face a serious test of its electability, having abandoned a significant part of their investment policies.

They had proposed to invest twenty-eight billion pounds in green energy projects over each of the next five years if elected, but have abandoned that plan to, in their words “concentrate on the economy, which has been decimated by the current government”.

A Conservative spokesperson commented that this showed that Labour cannot be trusted with the economy, since it was clear that the policy had not been fully costed and was unaffordable.

It is difficult to see how an economy that is going to avoid recession but merely “flatline” can bring any satisfaction to either Sunak or his Chancellor, Jeremy Hunt.

The right-wing press decided that the fact that Germany is in recession already is a cause for celebration, although there is far greater potential for both Germany and its Eurozone partners to recover and show significant growth over the next eighteen months.

The UK economy faces increasing risks before the next election, particularly if the Bank of England continues to raise short-term interest rates.

The Monetary Policy Committee meets next week with a hike being considered a foregone conclusion, despite a significant fall in the forecourt price of diesel fuel which should see another fall in headline inflation.

The May inflation report will be released tomorrow, with the claimant count expected to fall by close to 10k following last month’s surprise increase. The May inflation data will be published next Wednesday, so the MPC will have access before voting on monetary policy.

Last week, Sterling saw a return to a degree of strength as it established a foothold above the 1.25 level versus the dollar. A lot depends on monetary policy decisions in both London and New York over the next two weeks, but to continue its rise, the pound will need to see off resistance at 1.2640. Last week, it closed at 1.2579.

Having been determined to bring inflation under control before halting or even just pausing the Fed’s policy of interest rate hikes, it now seems that Jerome Powell is in favour of a pause, in order to “allow the economy to catch up with policy”, when the FOMC meets later this week.

Following more than a year of rate increases that has likely ended the low inflation/low interest rate period that started more than a decade ago.

This will bring a sea change to how economists view the economy. Some still see inflation as a concern while others believe that a rate cut may be necessary later in the year to provide support to what they expect to be an ailing economy.

Wall Street has seen the beginnings of a bull market in anticipation of the end of tighter monetary policy even though Powell is only likely to announce a pause on Wednesday evening.

It seems that a pause is factored into the interest rate markets, although interestingly, it is considered a far closer call that the Central Bank will resume hiking rates at its July meeting.

Having been at pains to say that Wednesday’s vote will only be for a pause in the cycle of rate increases, the market is still dubious about whether a single pause will have a material effect. A lot will depend on the June employment data which will show a full half year of significant growth in the jobs market.

When a pause was first mooted, the recent bank failures and drop off the availability of credit had been considered the main drivers. Now, although there may still be some skeletons lurking in the balance sheets of some regional banks, that threat has mostly gone away.

With the May inflation report due to be released tomorrow a pause is not considered a foregone conclusion, with the futures market pricing in a 25% chance of another hike.

It has been agreed that a fed funds range of 5% to 5.25% has become restrictive on demand, but core inflation still is uncomfortably high, mostly due to the still red-hot employment market.

It may now be old-fashioned to consider the Fed’s “bias”, but for what it’s worth, it still considers the risks to the economy skewed towards higher inflation.

Last week, the dollar continued to correct as traders remained uncertain about how investors would view a pause in rate hikes, particularly following the news that the Eurozone is halfway towards a recession.

The dollar index fell to a low of 10329 and closed at 103.55. There is likely to be some volatility this week following rate-setting meetings in both New York and Frankfurt.

In 1789, Benjamin Franklin wrote in a letter to Jean-Baptiste le Roy that there is nothing certain in life except death and taxes.

Economists are now adding a third certainty, and that is “no matter the state of the Eurozone economy, the European Central Bank will continue to hike interest rates. There is not even the faintest possibility that the ECB will end its cycle of interest rate hikes.

Last week, the European Commission announced that the contraction of the German economy when added to the significant fall in output from Ireland had tipped the entire Eurozone into a recession in the first quarter.

One must accept that there are some very sharp economic minds on the Governing Council, backed by any number of bright economists, but to continue hiking rates which are already considered to be in a restrictive state feels like overkill.

Christine Lagarde, the President of the Central Bank is determined to continue to hike rates further to “kill off” not just the current elevated level of inflation, but also the possibility of it returning.

The fact that the significant rise in inflation that has taken place over the past eighteen months is due to two events that could be considered rare if they happened in isolation but almost unheard of to occur simultaneously is lost on the hawks of the Eurozone.

The rise in wholesale energy prices which is clearly attributable to the war in Ukraine, which followed the historically elevated level of fiscal support that was pumped into the economy during and immediately following the Pandemic was unique and clearly warranted tighter monetary policy.

But it is obvious that the ECB “over-egged the support pudding” and has paid the price in higher inflation.

How much longer the tightening of monetary policy can go can only be a matter of conjecture. Lagarde says that the subject of an end to rate hikes hasn’t been discussed yet, while the “smart money” considers two more hikes to be sufficient.

It is unclear if the ECB may plan to follow the FOMC in the unusual step of considering a pause, given the more hawkish attitude currently prevailing in Frankfurt.

The ECB wants to declare a definite victory over inflation and not the possibility of one.

Last week, the Euro received help from the correction currently taking place in the dollar index. The common currency climbed to a high of 1.0787 and closed at 1.0748, snapping a four-week run of lower closes.

Have a great day!