14 May 2024: Bailey dismisses political concerns

The GDP data for the first quarter of the year bears out the story that the Prime Minister and Chancellor have been telling since the start of the year that if we just “stick to the plan” the economy will turn around and achieve a level of growth that had previously been considered impossible.

With interest rates at their highest since March 2008, the growth level seen since January is even more surprising.

Sunak and Hunt had begun to sound ever more desperate, particularly with a General Election looming, but now, the one area they seemed to have no chance of “getting right” was turning in their favour.

There are still significant issues to be tackled, like migration, the “Rwanda plan” is still hugely unpopular and proving to be incredibly expensive, the continuing supply of weapons to Israel which is ignoring all calls for a ceasefire in Gaza, and issues of NHS waiting lists.

None of these issues and several others will be solved by simply “throwing money at them” even if that was an option, which given the parlous state of the country’s finances isn’t, the Conservative Manifesto for the election will need to contain clear, achievable goals to set the country on a path to a better standard of living, by improving people’s lives, which means more than simply bringing down the cost of living.

The GDP data will have come as a shock to the Labour Party, which had been able to criticise the Government’s handling of the economy without having to put forward any alternative proposals.

Following the recent local election results, which were just as bad as predicted for the Government, the Prime Minister spoke about the likelihood of a hung Parliament in which no Party has an overall majority.

This seemed laughable at the time, but the fact remains that although the Opposition has a lead of almost 25% in opinion polls, it will need to produce an unprecedented swing to not only turn over the present Government’s eighty-seat majority but also command a working majority of its own.

Andrew Bailey was asked about the subject of political interference in a question-and-answer session yesterday. Since the Bank of England was given its independence in 1997, the question of aligning monetary and fiscal policy has often been raised.

Bailey has fiercely defended the independence of the Monetary Policy Committee, resisting calls for a representative from the Treasury to be appointed.

Traditionally, Central Banks have withstood the worst of political rhetoric across the globe,” Bailey remarked, acknowledging the inherent tension between politics and monetary policy.

The prospect of a rate cut just before an election is a contentious issue, with incumbent lawmakers often advocating for looser monetary policy to bolster the economy and sway voter sentiment in their favour. Conversely, opposition politicians may decry such actions as politically motivated.

The election will rival the prospects for loosening monetary policy once a date has been announced, but that is unlikely to be before the Autumn.

The April employment report is due to be published later this morning, with all eyes on the level of wage increases, which the Bank of England will hope has fallen sufficiently to allow them to cut rates at their next meeting.

Sterling rallied to the top of its recent range as the dollar reacted to speculation about the U.S. economy running out of steam. It climbed to a high of 1.2568 and closed at 1.2559.

The Regional Fed Presidents who currently sit on the FOMC appear to better understand the situation “on the ground” than the “permanent” members of the Committee. They are more aware of the “nuances” that affect monetary policy like supply chains and consumer demand.

For this reason, their opinions on when interest rates will be cut are more salient but no more important than those of the Fed Governors who head up various departments in Washington.

There has been a significant change over the past couple of months in the behaviour of Fed Presidents like Neel Kashkari, Austen Goolsbee, and Mary Daly who have seen the rate of inflation come close to stalling prompting them to push back their expectation for the first rate cut, while the permanent memes have long held views that cuts won’t take place until the Autumn at the earliest.

Now, with the economy possibly running “out of steam” with output beginning to top out, it may well be that those same Fed Presidents pivot again and vote for rates to be cut far sooner.

One of the most dreaded fears that Central Bankers face is stagflation.

Stagflation takes place in an economy that is hampered by high inflation, low economic growth and high unemployment. The situation currently is that inflation is relatively high, certainly from a historical perspective, but economic growth is “comfortable”, but unemployment is beginning to tick higher as the number of new jobs created appears to be slowing.

Jerome Powell has been hawkish about the possibility of an early rate cut, and several FOMC members have fallen into line behind him.

However, as hopes for the “fabled” soft landing have faded, the prospect of a far more significant issue has risen. Could the economy succumb to stagflation due to the Fed’s complacency over a cut in interest rates?

The data dependency that has become a glib byword for the FOMC sitting on its hands may take on a far more vital role as activity falls and inflation stalls.

The first indication of this taking place will be when inflation data is published later in the week.

No one seriously expected a significant fall in the headline rate, and it may well be that the current cycle is ending. This will present a whole new set of issues for Powell to deal with, which may need him to draw upon all his lawyers’ experience to keep the economy moving forward.

The dollar reacted to a feeling of unease in the market that the Fed may not be able to cut rates according to its agenda. The index fell to a low of 105.05 yesterday and closed at 105.21.

The Eurozone is between a rock and a hard place.

It is blindingly obvious from the data that has been published so far that the eurozone economy is in desperate need of a rate cut to galvanize activity and boost consumer demand, but deflation has been showing signs of slowing down after its precipitous fall late last year.

The Eurozone may well be facing similar issues to the rest of the G7 with its current economic cycle ending.

If inflation stops falling, the ECB faces an awkward decision on interest rates, since it has virtually confirmed that the first rate cut will take place next month, but on the other hand, has inferred that no cut will be approved until the headline rate of inflation has reached its target of 2%.

This week’s publication of inflation data has suddenly taken on greater significance than had been pervious assumed.

It may well be that the economy has bottomed out and with that the rate cut that is still expected next month may well be short-lived as the economy improves, driving demand higher and the euro nosedives due to its uncoupling from the dollar.

The worst of all circumstances for the ECB would be that a rate cut is agreed upon next month, despite Lagarde and Holzmann’s concerns, which needs to be reversed in the coming months as inflation rises and demand picks up.

If the geopolitical situation “conspires” against the region and a significant flare-up happens which sees the oil price rise, the ECB may find itself in deeper trouble than it is already.

While this is speculative, there is one issue facing the ECB that is certain to happen. The Central Bank “goes it alone” in cutting interest rates, the single currency will see a significant fall which will certainly increase inflation, due, “in no small part” to the velocity of its fall.

The ECB will then be left with another dilemma. Philip Lane, the Bank’s Chief Economist, believes that the first rate cut won’t take place in isolation and will be the first in a series of cuts. That will be difficult to achieve if the euro is sinking, driving up inflation.

The Euro is in a “holding position” currently where traders are loath to take on long-term positions for fear of being unable to exit them profitably, or even without taking significant losses.

Yesterday, the single currency rose to a high of 1.0806 and closed at 1.0788.

There appears to be significant interest to sell above the 1.08 level, which is likely to continue until June 6th.

Have a great day!