17 February 2023: Inflation guaranteed to fall… unless

At some point in the not-too-distant future, the Bank of England will bring to a close its programme of interest rates increases. At that time, the financial market will need to decide on the underlying strength of the economy, and whether that is sufficient to allow it to support the currency.

There is a growing concern that there are very few reasons to buy sterling outside the continued tightening of monetary policy. When that crutch is withdrawn, the pound could see a significant tumble.

Although the Federal Reserve is also possibly close to ending its own tightening, the ECB is still considered to have at least one hundred points of rate increases still up its sleeve, and this could see the pound test at least the 1.10 level versus the single currency.

In financial market terms, it has been a considerable time since the pound has found itself stripped of any support outside the basic economic fundamentals.

The Central bank has not exactly covered itself with glory over the past fifteen months or so as it has continued to perform a series of dovish hikes, where the Governor’s press conference following the announcement of yet another rate rise has had an almost apologetic air.

Andrew Bailey has not felt committed to the series of rate hikes that have taken place since December 2021 and this has been a function of a Monetary Policy Committee which contains several dissenting voices.

If the pound is to stand or fall based on the performance of the economy, the upcoming budget that will be presented to Parliament by Chancellor of The Exchequer, Jeremy Hunt on 15th March will need to inspire confidence that the Government remains fully committed to economic growth.

As Hunt said in an interview recently, the fact that the country avoided a recession in 2022 is welcome, but the economy is far from out of the woods yet.

Public sector pay remains a thorn in the side of the Government. Yesterday, nursing unions announced that they will begin to hold forty-eight-hour strikes beginning early next month and that A&E staff will be included in the walkout.

Similar actions have been announced by postal and railway workers, who plan to step up the pressure on Rishi Sunak.

The Prime Minister is facing a summer of discontent as a public sector revolt threatens to further damage any thoughts of the Conservative has of being reelected.

Sterling attempted a rally towards the 1.21 level versus the dollar, but a wave of selling drove it back to a low of 1.1965 leading it to close at 1.1992, the first time it has closed below the psychologically important 1.20 level since early January.

The credibility of the Federal Reserve has come under scrutiny several times since early last year, as it appeared fairly sanguine about the rise in inflation that went from being like a small bonfire to something akin to a forest fire in exceptionally quick time.

While it is unusual for a Fed Chairman to make off the cuff, almost glib remarks, the recovery from that nadir in Jerome Powell’s term as Head of the world’s most powerful financial institution while not being spectacular has certainly elevated his standing.

He has had to quickly learn how perception plays almost as important a part in confidence as the reality of hard and fast data.

While inflation has begun to fall, Powell has been staunch in his defence of the Central Bank’s continued tightening of monetary policy, and he was very clear in his view that the economy was not going to suffer a damaging recession in later 2022 as several prominent business leaders and bankers were advising caution.

He has proved himself to have a solid view of just how high interest rates will need to be in order to restrict the economy and dampen demand.

He has been as baffled as the rest of the financial community by the employment data, which was predicted to have seen the economy shedding jobs by now.

It may be that the move to cut the rate at which interest rates were hiked at the last FOMC meeting is considered to be inspired. The latest inflation data showed that prices continue to fall, and although they are not falling as fast as some commentators believe they should, the move heralded a subtle change in emphasis from the FOMC.

The data that has been released relating to January showed that the economy has begun the year in a far more robust manner than it showed in the final quarter of 2022.

The Fed’s data-dependence may be something of a smokescreen, while Powell and his colleagues of the FOMC remain fully committed to driving inflation lower while supporting full employment, which are, of course, their two primary goals.

Yesterday, the dollar index broke out of its narrow range to test its high so far this year. It reached a high of 104.23, closing at 104.03. In order for this rally to continue, it will need to break significant resistance at around 104.60.

It felt at the time that Christine had perhaps overstepped her mandate while testifying to the European Parliament earlier in the week. She appeared to go to Brussels with something of an air of doing little more than keeping MEPs informed of her intentions rather than seeking their approval.

To say that she intended to raise short-term interest rates by a further fifty basis points at the ECB’s next Governing Council meeting appeared to disregard the views of the rest of the Council.

While she may very well be firmly in favour of further rate increases to say that another fifty points is baked in, and that the Central Bank may then consider becoming more data-driven than it has been of late, makes any discussion on March 16th almost pointless.

Fabio Panetta, an Italian member of the ECB’s Managing Board, commented yesterday that the ECB should not unconditionally commit to future policy moves. The extent and duration of monetary policy restriction matters now that rates have moved into restrictive territory.

It is yet to be seen if rates have risen to the point where they are having an effect on demand. and it will take the February data to confirm that one way or the other.

The most recent activity, particularly that seen during the fourth quarter, means that it is too soon to be making any major pronouncements regarding the future size of interest rate hikes.

Ms Lagarde would have been far better served dialling back her comments, as she has counselled national governments to do with support for energy bills, despite her undoubted understanding of which way the wind blows across the European mainland.

She clearly feels that the frugal five have sufficient support now to ensure that fate increases will continue. However, if that is the case then a better degree of understanding of the less hawkish member states point of view would serve her better.

The euro, like sterling, is receiving significant support from the ECB’s current policy stance, but that doesn’t make it bulletproof. Yesterday, it was on the receiving end of renewed dollar strength. It fell to a low of 1.0654, and closed at 1.0673. It is likely to challenge support at 1.0640 should the dollar index exhibit more strength today.

Have a great day!