13 July 2023: The Bank of England feels the economy can cope with more rate hikes

Andrew Bailey has, rightly or wrongly, become the face of unacceptable high inflation.

In his annual Mansion Speech at a dinner hosted by the Lord Mayor of London, Bailey spoke of the resilience of the UK economy and the fact that, in his opinion, it can stand further hikes in interest rates.

The Bank surprised the Market last month by raising interest rates by fifty basis points as inflation remains stubbornly high.

Bailey believes that since food inflation has peaked that the overall rate of inflation will fall quickly, and Rishi Sunak’s pledge to halve the rate of inflation by the end of the year remains attainable.

Since December 2021, interest rates have been hiked from 0.1% to their current level of 5%, yet they still don’t yet appear to have reached a level at which they are restricting demand which remains strong.

In its mid-year review, the Bank’s economists concluded that although there will be no significant growth in the current year, further interest hikes are unlikely to tip the economy into a recession, although any further shocks could change that perception.

Bailey agrees that the economy is “coping well” with interest rate rises, and he feels that this is a testament to the approach adopted by the Central Bank. He and his colleagues will “keep an eye” on the level of household debt, which continues to rise, and will try to ensure that credit conditions don’t lead to a tightening that isn’t explained by the current economic situation.

Banks in the UK are less exposed to credit conditions than their European neighbours, due to the “broad resilience” of the sector.

It is estimated that more than a million households will face an increase in their monthly mortgage payments of five hundred pounds between now and the end of the year as fixed-rate mortgages are repriced. Buy-to-let landlords are expected to be the hardest hit, given the high degree of leverage that has crept into the sector over the past year or so.

The pound rose again yesterday and is now threatening the 1,30 level against the dollar. Its rise from a low close to 1.04 over the past nine months can rightly be called meteoric. It reached a high of 1.3004, closing at 1.2986 as the fall in the headline rate of inflation in the U.S. weighed on the dollar.

The headline rate of inflation fell to its lowest level in more than two years in June, even though the Federal Reserve chose to pause its cycle of rate increases that has been in place for over a year.

The rate fell to 3%, which exceeded market expectations and could lead to the Central Bank reconsidering its decision to hike rates at this month’s FOMC meeting.

While there have been several members of the committee who, until yesterday, had supported another hike, the data may cause them to reconsider.

Only Raphael Bostic from the Atlanta Fed has so far called for a continued pause, although Jerome Powell has said that the frequency of hikes may become less going forward.

A soft landing for the U.S. economy has become a genuine possibility as inflation has been brought down close to the Fed’s 2% target with no recession in sight.

Core inflation, which has the more volatile items like energy and food items stripped out, remains a concern, although it too is “moving in the right direction”.

It fell to a low of 4.8% last month from 5.3% in May. This was a larger fall than the market had expected.

Lael Brainard, the former Deputy Chairperson of the Federal Reserve, and many people’s choice to be Jerome Powell’s successor, who is now the Chairperson of the National Economic Council, the body that advised President Biden on economic matters, spoke of her confidence that with inflation falling and employment appearing more balanced, the Fed has set the country on a path to strong growth in the coming months.

She feels that the actions of the Central Bank have “pushed inflation over the mountaintop”. She believes that the Fed was right to aggressively face inflation “head-on” and is now reaping the rewards of its decisive action.

The dollar index suffered badly from the market’s perception that the inflation data could see the Fed end its cycle of rate hikes. It fell to a low of 100.50 yesterday and closed at 100.58.

It has now fallen through several lines of support so far this week and is now open to a test of the psychologically important 100 level.

It may be little more than a “sop” to its more dovish members, but the agenda for the meeting of the Governing Council of the ECB will include the raising of the inflation target which may have now become “out of date” as the economic outlook has changed irrevocably to show that inflation still lurks and can rise to challenge economic stability is rates are allowed to fall close to zero as was seen in the recent past.

It is certain that a vote on the increase will be less successful than a vote to raise interest rates again. The mood of many of the Central Bank heads who make up the Governing Council has been summed up perfectly by the President of the Cypriot Central Bank, who spoke of “high inflation being more destructive than high interest rates.”

Another item on the agenda at the meeting being held two weeks from today is to consider whether to publish the votes of individual members along with the minutes of the meeting.

It is felt that this would make the entire process more transparent, although it may also reveal some interesting facts, particularly about some of the less prominent members.

While it is generally accepted that the “frugal five” vote almost as a bloc for higher interest rates, and the countries that make up the “Club Med” are in favour of slowing the number of hikes, France is thought to change its vote “depending on the wind direction”, not wanting to appear to be out of step with Germany, but also feeling that it speaks for the weaker economies, as it is now considered one.

There are unique issues facing several Eurozone nations in the coming months. For example, there are elections in Spain where there are a number of smaller radical factions which may disrupt the vote, while in Austria, there is a battle to lose its tag as Europe’s unfriendliest nation, which is significantly affecting its tourist sector.

In France, it has been another summer of social unrest while President Macron has pledged his support for his embattled Prime Minister, who was the architect of the hugely unpopular pension reforms.

The euro has now emphatically broken the 1.10 level versus the dollar, although its recent rally still doesn’t look solid. It reached a high of 1.1140 yesterday and closed at 1.1130. A continued rally will also aid the ECB’s fight against inflation, making imports cheaper.

Have a great day!