14 June 2023: BoE – First to start, last to finish

The Bank of England appears certain to hike rates when the MPC meets next week. Andrew Bailey, the Bank’s Governor virtually confirmed the need for still higher rates during his testimony to the House of Lords.

He confirmed his view that inflation will eventually fall back close to the Government’s target of 2%, despite it taking significantly longer than anyone at the Central Bank had first imagined.

Bailey has received criticism from MPs in the past for being too timid in dealing with rising inflation. While other G7 Central Banks have increased the size of the increments of their own tightening of monetary policy, the MPC has “plodded along” hiking by twenty-five basis points at each of its last twelve meetings dating back to December 2021.

Yesterday he quoted data that had just been released showing that private sector wage growth continues to show an extremely tight labour market.

In the three months to April, wages in the private sector rose by 7.6%. He was asked if the Bank of England could have done more in the early days of the current cycle to prevent the current situation.

He answered that a Central Bank must be concerned that the process of raising interest rates with the goal of lowering demand to bring inflation under control can send the economy into a period of lower growth or even recession.

The Governor was asked if he believed the next General Election could be fought in the face of a recession. Bailey replied that it is not the Bank’s “base case” that the economy will fall into recession, although he would not be drawn on how many further rate hikes will be necessary to bring inflation “into line”.

It was put to Bailey that the Bank of England may push interest rates up to such a level that a recession becomes inevitable.

Last weekend, major UK lender Santander withdrew all “tracker” mortgages for new borrowers considering “current conditions”; this is a sure sign of stress in the money markets.

A report from the council of mortgage lenders, published yesterday spoke of a “bloodbath” for borrowers as rates continue to rise, and the issue could easily spill over into the rental market as a spiral of higher rates and slowly falling inflation prevails.

The pound rose to a high of 1.2624 as the dollar corrected further. It stayed strong throughout the day and closed at 1.2611, its highest close in a month.

The May inflation report was released yesterday as the FOMC convened for its latest two-day meeting. While there were expectations that the headline rate would fall, those expectations were surpassed as it fell to 4% against predictions of 4.1%

The core rate also fell, but by a far smaller amount, dropping to 5.3% which was the market’s advance prediction.

This was the eleventh month in a row that prices have fallen, and headline inflation is now at its lowest level in two years. It also all but confirmed that the FOMC will pause the cycle of interest rate increases that have been going on for a year.

The press conference that will follow the rate announcement will be attentively listened to by economists, commentators and investors alike for signs that the pause may last for more than just one meeting, or, in light of the pace of the fall in the rate of inflation if Jerome Powell and his colleagues believe that inflation is under control and will fall to its target “naturally”.

The latter scenario is unlikely to come to fruition since Powell will want to oversee a drop to close to 2% while continuing to exert a high degree of control.

In the inflation report, the major contributors were gasoline prices, which have fallen by 20% and, curiously, eggs, the cost of which has fallen by almost 14%.

The Chief Economist at rating agency Fitch warned that since almost the entire fall was due to falling fuel prices, underlying the data, there are still some significant price increases which will prove to be a drag going forward.

Having risen to a high of 9.1% in the wake of the invasion of Ukraine by Russia, the Fed can be satisfied that the headline is now more than half that level, but to finish the job, there may well be further increases on the horizon.

The data led to traders selling out of long dollar positions as the support provided by higher rates subsides. The dollar index fell to a low of 103.04 but recovered a little later in the day to close at 103.29.

As the global economy becomes more interconnected the likelihood of G7 and even G20 countries all suffering from high inflation and/or sluggish growth at the same time becomes ever more prevalent.

Taking Japan aside as its economy “marches to a different beat”, the UK, U.S. and Eurozone economies and even Switzerland, Australia and New Zealand have seen similar repercussions.

The macro make-up of developed economies is such that raising interest rates, a move that had “gone out of fashion” in recent years, becomes their most effective tool to bring inflation down.

Although there are “economic idiosyncrasies” to each country and their Central Banks may see the relationship between economic activity and rising prices a little differently, by and large once one Central Bank sees an opportunity to slow or pause interest rate hikes, the others will likely follow.

The Fed is expected to pause its cycle of interest rate hikes later today while the Bank of England, where the fall in inflation is a little more sluggish, may hold out for a month or two before also pausing.

The ECB, clearly more hawkish than its G7 partners, wants the market to believe that it hasn’t even discussed a pause yet despite most market practitioners believing that the hike that will be announced tomorrow and one further hike will be sufficient to control inflation.

The three Central Banks will act similarly if not in unison and therefore the ECB must be close to a pause despite its protestations.

Tomorrow’s new conference facing Christine Lagarde may find her struggling to justify more than one further hike as the ECB is facing a similar set of circumstances that Jerome Powell will have faced twenty-four hours earlier.

How she handles the questions from journalists will be interesting since she is now running out of reasons to be hawkish.

The Euro rose following the May inflation report in the U.S. It climbed to a high of 1.0823 but found the atmosphere a little too rarefied and fell back to close at 1.0793.

Have a great day!