13 December 2023: The Bank of England won’t cut yet

The latest employment report shows that pay growth slowed by the most it has in two years in October, while the claimant count rose significantly in November.

Despite the fall, pay growth is still rising too much for the Bank of England to consider cutting interest rates, even though the economy is beginning to slow.

Under the stewardship of Andrew Bailey, the Bank has failed to act proactively, even though it was the first in the G7 to begin to hike rates.

Bailey is not enough of a forward thinker to be able to convince his colleagues on the MPC on a course of action that they will consider “alien”. When one considers that the rate-setting committee is split across several fault lines, a radical approach will be impossible to achieve.

While the permanent members indulge in “groupthink”, almost allowing Bailey to use their votes as he sees fit, the independent members believe that either inflation is not yet under control and therefore rates need to rise again, or that a recession is imminent, in which case a cut should be seriously considered.

This makes the role of the independent member little more than cosmetic.

The data published yesterday showed that the higher rates are having an effect. The UK is the first economy to see employment being affected by tighter monetary policy. Data released recently in the U.S. last week showed that the number of new jobs created in November was far higher than it should be at this point in the economic cycle, while in the Eurozone, even if the data is unreliable, it is still showing that job creation is taking place.

Average pay still rose by 7.3% in the three months to October, half a percent lower than in the three months to September. With inflation having fallen to 4.6% in October, down from 6.7% in September, pay growth is now well above the rate at which prices are rising.

The Bank of England will hope that the gap will close over the coming months, but output data as shown by the latest PMI data means that they may not have time on their side.

With another pause almost certain to be agreed at tomorrow’s MPC meeting, Bailey’s press conference will take on even greater significance than when he was presiding over the cycle of rate increases.

The market showed an unexpected amount of volatility yesterday, although its net effect was negligible. The pound traded in a surprisingly wide range between 1.2615 and 1.2514 against the dollar but ended just a few points higher at 1.2569.

The best that market observers can expect to see from today’s FOMC meeting is that Jerome Powell confirms that the Committee at least discussed rate cuts, even if they are considered to still be two quarters away from happening.

However, since Powell will not even confirm that the Fed has ended its cycle of interest rate hikes, he is hardly likely to acknowledge a course of action which will all but confirm the idea that inflation has been defeated.

Data published yesterday, showed that while headline inflation continues to fall, even at a pace that is too slow for the Central Bank’s liking, core inflation remains uncomfortably high.

Headline inflation fell from 3.2% in October to 3.1% in November, while the core, with energy and other volatile items stripped out, remained at 4%.

The FOMC faces three possible scenarios in the first few months of the New Year: soft landing, recession or a reacceleration.

Current conditions appear to rule out the latter, which leaves the market to ponder how likely a recession is given the stellar level of growth that was achieved in the third quarter.

Data released so far in the current quarter has shown that the economy may have slowed from that level as rate hikes continue to work their way through into the economy, but not by anything near enough to drive a contraction.

It is true, and the FOMC will be very much aware, that they will need to cut rates towards the middle of the year, but that will be a conscious decision, not one that is forced upon them by unforeseen events.

Powell will most likely say that 2023 was a difficult year with inflation touching 9.1% and making the series of rate hikes not only necessary but vital. He will not accept praise for simply doing his job, and will say that inflation hasn’t yet been defeated, even though hikes are having some effect.

As well as Powell’s usual post-meeting press conference, the Fed will also update its projections for growth, inflation and unemployment. It will also provide projections for interest over a one, two-and three-year horizon.

This will most likely provide the market with greater insight into the thinking of the FOMC than Powell’s comments.

Traders clearly believe that the cycle of rate hikes is now at an end, judging by the reaction to yesterday’s data. The dollar index fell to a low of 103.48, but recovered to close at 103.81, still well within its recent range.

The ZEW Institute published its projections for economic sentiment in both Germany and the wider Eurozone yesterday.

Current conditions in Germany are still at an all-time low, even though they did marginally improve from -79.8 to -77.1, economic sentiment showed a significant improvement, rising to 9.8 to 12.8, although this may be respondents to the survey believing that conditions cannot get any worse.

The data for the entire Eurozone was far more encouraging. ZEW doesn’t publish data for current conditions, deeming it too difficult to obtain individual nation’s data in a timely manner.

Sentiment is on the rise across the Eurozone as a whole, most likely driven by the fact that there has been confirmation from the ECB that it has ended its programme of rate hikes, while there is a growing belief that rates will be cut sooner rather than later, possibly as soon as the end of the first quarter.

Today’s meeting of the Governing Council of the ECB is unlikely to provide anything other than an acknowledgement that, in its view, rates will need to remain elevated for a considerable time for inflation to be finally defeated.

The market’s view differs from that of the Central Bank. Despite the encouraging data, the economy is sliding towards a recession, and the ECB may be overtaken by events on the ground.

However, it is doubtful that the ECB will be driven to cut rates even if the region suffers a mild recession, but if observers’ worst fears are realized, they may be left with no choice.

The rate at which inflation is falling, 2.9% last month, down from 4.3% the previous month, will provide the Governing Council with some encouragement, but they still seek the “holy grail” of 2% inflation and until that is achieved, they are expected to retain a hawkish bias.

The euro was driven higher yesterday by the market’s reaction to the U.S. inflation data. It rose to a high of 1.0828, but was unable to break through short-term resistance and fell back to close at 1.0797.

Once the three Central Bank meetings scheduled for this week are over, the market will probably feel comfortable to enter holiday, or end of year, mode and it will take an unexpected turn of events to drive the major currencies out of their established ranges.

Have a great day!