Rate decision, a close call

The Bank of England’s rate setting Monetary Policy committee will vote later this morning on whether to hike interest rates as inflation in the UK hits a ten year high of 5.1%.

Producer prices, the cost of goods at the factory gate, also hit a high in November, reaching 14.3%, up from 13.7%. This data provides a clue to the future path of consumer price inflation.

A month ago, the outcome of today’s meeting would have been an easy decision.

The Bank’s Governor following the previous meeting had commented that the MPC had decided to leave rates unchanged until they saw the effect of the withdrawal of the Government’s furlough support scheme, until considering a rate increase.

Given the encouraging employment report that was published earlier in the week, it would seem that condition had been met, but the rapid increase in the number of cases of the Omicron Variant has again placed a rate hike in doubt.

Market sources now expect the vote to be the same as last month, 7-2 in favour of leaving rates unchanged.

Given the uncertainty of the effect of the continued rise in cases of Covid-19, this will be enough to convince the seven doves to wait.

In normal circumstances, given the pace of the rise in inflation, such a decision would be questioned, even criticized, but given the increased level of uncertainty, it is likely to be considered understandable.

Huw Pill’s recent comment about the burden of proof now has to be disregarded, since, from a purely economic perspective, a hike is needed to dampen inflation, but now, the wider perspective means that a decision can be deferred to allow the picture regarding the effect of greater numbers of infections to become clearer.

There was a record number of new infections reported yesterday, with the total coming close to 80k in a single day.

The pound has been under pressure from the outcome of yesterday’s FOMC meeting in the U.S., so it is unlikely that a vote to leave rates unchanged will have a significant effect.

Sterling fell to a low of 1.3172, actually closing higher on the day at 1.3260.

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FOMC focus shifts from jobs to inflation

In the end, the FOMC doubled the rate at which it will withdraw support from the economy, as, to quote Jerome Powell’s words from a previous meeting, the time has come for the Fed to put away the emergency tools.

In his post meeting statement, Powell commented that it would be inappropriate for interest rates to be increased while the withdrawal of support is still taking place. He cited market sensitivity for the Fed’s more methodical approach to tightening monetary policy.

With economic activity set to have a robust end to the year, which is expected to continue into 2022, such an outlook demands an acceleration of the pace of the taper.

While the risk of Omicron continues to be a concern, the balance of risks now favours tighter monetary policy.

Pandemic driven support for the economy will be fully withdrawn by March next year, giving way to an anticipated three rate hikes, each of twenty-five basis points.

Rising prices and wages are in stark contrast to the near-depression outlook at the start of the Pandemic, and this warrants a tightening of policy.

With rapid progress being made towards full employment and inflation remaining uncomfortably high, the committee agreed that the time is right for an end to historically loose policy.

One concern voiced by the Fed Chairman was over the labour market participation rate. He believed that the rate would surge as the conditions around the Pandemic were loosened, but that hasn’t happened. He now believes that this will take time.

The economy cannot afford to wait for the participation rate to catch up. since inflation now needs to be brought back under control.

One piece of negative economic data that was released yesterday was a disappointing result for retail sales in November. Versus a market expectation of a rise of 0.8% and a previous rise of 1.8%, retail sales in November rose by just 0.3%. This may have reflected concerns about the arrival of the new variant and is expected to have been a blip.

The dollar index rallied to a high for the year in the immediate aftermath of the FOMC announcement but fell back to close a little lower on the day. It hit a high of 96.91 but fell back to close at 96.34.

Central Bank in danger of becoming predictable

Historically, it never pays to second guess a Central Bank, and it has been proven repeatedly that they eventually bend the market to their will.

However, times may be changing.

The amount of advance guidance provided by Christine Lagarde regarding the level of support that the ECB is going to provide to the Eurozone economy going forward has lulled the market into believing that the euro has become a one-way bet.

While it is fairly clear that the ECB will confirm its dovish outlook at today’s meeting, in the background is a slightly more hawkish groundswell of support for a gradual taper of bond purchases. The level of support being received by Spain which was discussed yesterday has come as a surprise to market participants.

Seeing in black and white that the ECB owns close to a third of all Spanish Government debt and has been the only buyer for close to two years has come as something of a shock.

Lagarde remains sanguine about Central bank support, clearly believing that its role is far more than policing the nineteen economies of the Eurozone.

The policy of putting growth above inflation was considered a nuclear option when it was first introduced, but the length of time it is likely to last if Lagarde gets her way will imbed such a policy in the thinking of several Central Bank Heads and Finance Ministers for years to come.

The question of the withdrawal of support is being studiously avoided by all but the most hawkish of member states and is a reminded of the policies adopted by the countries who relied upon high inflation and high interest rates before the advent of the Eurozone.

If the Omicron variant continues to affect growth across the Eurozone economy with bottlenecks getting worse as lockdowns continue, the economy will see continuing insipid growth while inflation shows no sign of abating.

At some point, possibly at today’s meeting, questions are going to be asked about the exit strategy from the current dovish policy. Lagarde’s answer to that question will be the most crucial factor that can save the euro from another period of at least two quarters of weakness as Central bank policy diverges.

Following the FOMC announcement, the euro fell to a low of 1.1221, but it bounced back to close at 1.1287.