14 July 2023: The city believes that Bailey can no longer be trusted

In times of high inflation, the delicate balance between fiscal and monetary policy needs to be tightly controlled because if they become unbalanced, it can prolong the “economic agony” being experienced by the country.

It was not very long ago that the Government was saying that public sector pay awards above 5% would add to inflation and cause the Bank of England to tighten monetary policy as a pay/price spiral developed.

In the past few days, pay increases of between five and seven per cent have been announced while the Bank of England recently raised interest rates by fifty basis points, in a departure from the twenty-five that had become the “norm” over the past eighteen months or so.

The level of Government borrowing is already at 100% of GDP and is set to rise even further in the coming years as high-interest rates increase the debt servicing burden while the government is still trying to pay for the support that was provided during the Pandemic.

Add to that an ageing population where there are fewer tax receipts and the “triple lock” on the state pension where an annual increase guarantees that pensions will not lose value in real terms, and the dilemma facing the treasury becomes apparent.

Figures published by the Office for National Statistics yesterday show that the UK has potentially, by far, the most serious debt issue in the G7.

Significantly increased interest payments on its borrowings coupled with considerably higher outgoings in benefit payments will see the level of investment in public services and infrastructure projects decline.

The Bank of England recently completed its stress tests on the financial sector. Andrew Bailey pronounced himself satisfied with the results and as a former head of Financial Regulation, which should be good enough. However, the results of the tests have raised some serious doubts in the City.

The first question is why were only the eight largest institutions tested? It is obvious that by their size alone, they present a significant risk, but they are already heavily regulated. The second tier of banks was not tested, presumably because they are not seen as a “threat to the system”. It is being argued that in the current times, with increased volatility and interest rates set to rise further, the combined exposure of the second tier could be very significant indeed.

The next question is round why the examination only tested banks against a hike in base rate to 6% when it was already at 5%, and the expectation is that the base rate will rise this year to 6.5% or even 7%.

Bailey’s credibility is on the line again, and if there were to be a financial crisis with its basis in the bank’s inability to cope with higher interest rates, serious questions will be asked.

The pound took out the 1.30 level against the dollar with ease yesterday as it continued its recent bout of strength, rising to a high of 1.3141 and closing at 1.3135.

The fall in the headline rate of inflation in May to 3% not only increased speculation that the FOMC will continue its pause in interest rate hikes for another month, but also showed that the “finishing line” is in sight.

It was only relatively recently that Jerome Powell was being questioned over his sanguine approach to driving the economy into a recession.

Following the upwards revision of the first quarter growth data, the cooling of pressures within the jobs market and now the fall in the rate of inflation, it is now possible that the Fed may have engineered a soft landing for the economy.

Even though the “naysayers” are saying this was more by luck than judgement, Powell deserves immense credit for “sticking to his guns” and applying his lawyers’ brains to an economics problem.

Over the past year, he has not been short of advice, with captains of tech and industry saying that it would be impossible for the country to avoid a recession, while the CEOs of some of the largest financial institutions railed against further regulation in light of the failure of three regional banks earlier this year.

Where there have been serious divides developed in other central bank rate-setting committees, there has been “lively debate” but nothing more at the Fed.

Powell has listened to Fed Presidents express their concern that regional economies are faltering, and that rate hikes should be paused. That happened, but prior to the inflation data, everyone commented that they would vote for a hike at the next meeting.

That attitude may have changed again, showing that the Central Bank is truly data-dependent. It also shows that flexibility is vital, given that there are not that many tools that can be used to fight inflation.

The idea that the Fed may not only pause again at its next meeting but announce the end to its cycle of hikes has “pulled the rug” from under the dollar.

The index fell below the psychologically important 100 level yesterday, reaching a low of 99.74 and closing just one pip higher. It has fallen for the past six sessions consecutively and was last at this level in mid-April last year.

While inflation and interest rates were low and support was readily available to any EU member states that were suffering, the “eurozone experiment” was seen to be functioning well, but as any sailor knows that it is only during stormy weather both the vessel’s seaworthiness and the ability of the captain are truly tested.

So, it is proving in the Eurozone currently.

The weaker economies could handle the first few interest rate hikes, in fact, they were generally supportive of relatively higher rates since it injected a certain “normalcy” into the economy following the turmoil of the Pandemic. But now, despite the “temporary abandonment” of the growth and stability pact, those economies are bleeding.

In the run-up to the next meeting of the Governing Council of the ECB, serious rifts are developing between the hawks and the doves, and it may not be the most equitable time to introduce the greater transparency of publishing the votes of individual members that is the practice in other G7 members.

There have been some instances recently of the blurring of the lines between political and economic considerations despite the fiercely guarded independence of the ECB.

When Italy elected a far-right politician as its new Prime Minister, following the eminently capable and financially savvy Mario Draghi, it was seen as a prelude to calls for “Italexit,” particularly given the country’s vociferous opposition to EU immigration policy, and Italy’s parlous financial position.

But, again, since the “waters of the EU” were calm, Giorgia Meloni, Italy’s first female Prime Minister, busied herself solving the country’s social problems.

Now, as the rates being charged by the market have reached critical levels and the ECB remains on a path to even higher rates, a rebellion is in the air. The Head of the Bank of Italy has put forward a proposal for rate hikes to be frozen while the ECB commits to keeping rates at the current level for the foreseeable future, and this will be discussed at the next rate-setting meeting.

If a hike is agreed this month and another at the September meeting, the rift could widen even further, possibly even to the extent that continued membership of the Union is questioned.

The Euro continued its journey north yesterday unimpeded. It reached a high of 1.1228 and closed at 1.1226. The next target is around 1.1490, but there is sure to be some correction before that level is seen.

Have a great day!