14 June 2024: The BoE is prepared to wait for inflation to fall

Three weeks today, one of either Sir Keir Starmer or Rishi Sunak will enter 10 Downing Street as the country’s Prime Minister for the next five years. If the polls are believed, that privilege will fall to Starmer as the Conservative Party begins an indefinite period in the political wilderness.

It emerged yesterday that the Reform Party may have overtaken the Tories, and if this voting intention converts into seats won, this will be the first time in over a hundred years that neither of what had been considered the main Parties forms the official opposition,

The vagaries of the “first past the post” electoral system mean that a Party can receive proportionally more votes but not win as many seats as expected.

Nigel Farage spoke this week of a huge change about to take place in the UK’s centre-right political landscape, with a new Party being formed by his Reform Party and the “debris” of what is left of the Conservatives.

Naturally, he sees himself as being the person to lead that Party which will become the official opposition.

All three main Parties have now published their official manifestos, so the public has now been given all the information that it is going to receive to make an informed decision on July 4th.

However, since this election is as much about trust as it is about change, the question is still; can either the Labour or Conservative Party be trusted to stick to its commitments?

In the case of the Labour Party, can it be believed that their commitment not to raise direct taxation even though their manifesto promises are based on a need for the economy to grow better than it has on average under the current Government?

It is difficult to know where to start on the level of trust that has been demanded by the Conservatives, given their atrocious record during this Parliament.

The manifestos themselves were turgid. None of the three (or four) main parties plans to make radical changes that will bring meaningful change to the key issues like immigration, or health and social care.

Labour believes the rhetoric that all it needs to do is avoid any “banana skins” to win the election.

However, as polling day approaches, will the voting public feel that they will make enough of a change to achieve the level of economic stability they promise?

Next week, the May inflation report will be published. The expectation is for inflation to be unchanged at 2.3%. That is unlikely to persuade the Bank of England, whose Monetary Policy Committee also meets next week, to cut the base rate of interest. Should headline inflation remain unchanged, Andrew Bailey may hint at a rate cut happening by September.

Yesterday, the pound “gave back” more than 50% of the gains it has made this week against the dollar.

It fell to a low of 1.2738 and closed at 1.2762.

The markets are becoming less and less infatuated by the prospect of an interest rate cut if the economy continues to produce positive growth and job creation data.

This makes Minneapolis Fed President, Neel Kashkari’s recent comment that U.S. consumers hate inflation almost as much as their counterparts in the Eurozone, less believable.

It seems that while consumers were not enamoured by inflation at five per cent and above, they can live with the current level.

The Fed wants to see wage growth well below the headline rate of inflation and will resist a rate cut until that happens consistently.

However, with hourly earnings rising by 4.1% in May and headline inflation at 3.3%, the gap is too large for the Fed to consider anything but leaving rates unchanged.

Jerome Powell is indeed too naturally cautious to make an outstanding Fed Chair, in the manner of Greenspan or Bernanke. Neither former chairman has so far commented on the Fed’s performance during the Pandemic or its immediate aftermath.

Likely, that will only happen once Powell’s term has ended.

The news that the FOMC only expected to be able to cut interest rates once this year has proved positive for the dollar but has failed to quell the exuberance of the equity market.

The Dow Jones index closed yesterday at 38,647 and remains close to its all-time high.

Next week sees the release of retail sales data as well as industrial production, and real estate data. Provided the data is still within its recent range, the dollar should continue to be mildly supported.

Yesterday, the dollar index rallied to a high of 105.28 eradicating its earlier losses. It eventually closed at 105.23.

The ECB is unlikely to move again on interest rates until it has solid evidence to do so.

Since it doesn’t expect the headline rate of inflation to fall to its 2% target for close to eighteen months, it will have to abandon its requirement for that to happen if it is to continue to support the economy.

Christine Lagarde has noticeably pared back her plans for rate cuts to happen regularly but is avoiding any consideration that the rate cut that was agreed at last week’s meeting of the Governing Council will be the only one in the current cycle.

The nature of the inflationary cycle in the G7 and the industrialized nations beyond that is that of the Pandemic and its immediate aftermath have ushered in a new paradigm in which inflation may never fall below 2% rendering the target used by the majority redundant.

The ECB may stand alone in trying to ensure that inflation can fall further, even as the headline rate “ticked up” last month despite a significant period in which interest rates were restrictive.

Central Banks are faced with a stark choice; to keep interest rates at a restrictive level, which may control the level of inflation, or see inflation remain consistently between 2.5% and 3.5%.

In the Eurozone, it may well take until a new generation of Central Bank Governors takes over for that attitude to change.

Meanwhile, market participants will be party to the constant battle between those who can cope with relatively high inflation and those to whom it is an anathema.

The euro appears to have begun its long road lower. Several levels of support will need to be breached before it reaches its medium and long-term targets of 1.044 and 1.0175.

It is likely that the “long march” will only end with a rate cut in the U.S.

Yesterday, the single currency fell to a low of 1.0732 and closed at 1.0737.

Have a great day!