17 July 2023: Inflation fall is unlikely to change BoE’s mind about further hikes

Inflation data will be published this week, and although the headline rate is expected to have fallen, the fall is unlikely to deter the Bank of England from hiking rates for the 14th consecutive meeting.

Since the rate of food inflation peaked in May, inflation has remained significantly higher than in both the Eurozone and the U.S. It was at 8.7 year-on-year in May and will have fallen to around 8.2% in the twelve months to June.

That is not going to satisfy the Bank of England which signalled its hawkish intentions with a rate hike of fifty basis points at the last meeting of the MPC, after a string of twenty-five-point hikes.

Headline inflation fell to 3% in the U.S., when it was published last week, while in the Eurozone, despite an extremely hawkish Central Bank, headline inflation has only fallen to 5.5%

The Bank of England has been hiking rates continuously since December 2021, but it has been hampered by what have been considered “dovish hikes” which have been more inclined towards controlling rather than lowering an inflation rate which became uncontrollable.

When the past two years are analysed, it is likely that the Bank was hampered by two issues that were out of its control and one which could and should have been handled better.

The changes in fiscal policy which saw the “triple lock” on benefits led to state pensions and other benefits rising by 10% which undoubtedly added to headline inflation. Added to that the issues with supply created by both Brexit and the conflict in Ukraine have been a factor.

Supplies of pharmaceuticals from the EU and basic foodstuffs from Ukraine were particularly badly hit, while the energy crisis was a constant for all.

Where the Bank has come in for criticism is for its lack of “dynamism” throughout the second half of last year. While the Fed and ECB were increasing rates by fifty and on occasion seventy-five basis points, the Bank of England, fearing tipping the economy in a recession, stayed with twenty-five points.

The Bank of England will raise again when its meeting takes place on August 3rd. Given the lack of progress on inflation falling towards its 2% target it is likely that another fifty basis points will be added to the base rate.

Sterling has been benefitting from the newly hawkish attitude of the Central Bank and that is unlikely to change in the near-term.

Last week, the pound reached a level against the dollar that hasn’t been seen since April last year. When it last reached a high above 1.3140, it signalled the start of a fall as political scandals that culminated in the resignation of Boris Johnson and the brief tenure of Liz Truss.

It ended last week at 1.3092.

The Federal Reserve has entered something a little like the “twilight zone” where it has become close to winning its battle with inflation but now has a slowing economy to contend with.

While several members of the Administration, including Lael Brainard, a former Vice-Chair of the FOMC and now Head of the National Economic Council, have declared victory, that is unlikely to deter the FOMC from considering another hike when it meets next week.

Although headline inflation fell to 3% in May, core inflation. Which is affected by what are called “secondary effects” is still uncomfortably high.

The minutes of the latest FOMC meeting made it very clear that the pause in rate hikes that was agreed was a “skip” for one meeting only, and although there have been dovish comments from FOMC members over the past week or so, most appear to agree that now is the time to administer the “coup de grâce” by one, or maybe two further hikes.

The economic data that is due this week will make some members of the FOMC uncomfortable. First retail sales which are due tomorrow will have risen compared to May, but not by enough to convince the market that the economy will see a stranger second half than was seen in the first.

Sales are expected to have risen by 0.5% in June, after a 0.3% increase in May.

Later this week, data for building permits and housing starts will be released. The state of the property market permeates through the entire economy and a continued slowdown could hasten the Fed’s decision to end its cycle of rate hikes.

The market has convinced itself that even if the Fed hikes rates at next week’s meeting, the end of rate hikes is imminent and has driven the dollar index to lows not seen in over fifteen months consequently.

Last week it fell below the 100 level for the first time since April last year. It reached a low of 99.57 and closed at 99.94. Given the disparity between the economic outlook for the U.S. and its G7 partners, it is unlikely that the precipitous fall seen last week will be repeated, and the index may see a reasonably strong recovery, although these levels may remain until the result of the FOMC meeting is known.

There is another argument brewing within the Eurozone, but the subject this time is not interest rates, but the treatment of windfall profits made on the frozen assets of the Russian Central Bank that are under the joint control of the European Union and the ECB.

This European Commission headed by Ursula von der Leyen believes that the profits should be used to begin the rebuild of Ukraine, particularly since the assets were frozen in the first place due to Russian aggression towards its neighbour.

The ECB wants to be more cautious. Treating the profits as windfall taxation could undermine the euro. Christine Lagarde believes that although the European Commission is the custodian of the assets, any decision on the approximately three billion euros of profits should be made by the G7 group of industrialized nations.

Germany has sided with the ECB, commenting that any “hasty move” could lead to legal or financial risks.

Last week, saw industrial production across the entire Eurozone tick a little higher. Industrial Production rose by a paltry 0.2% in April, while in May it rose by 1%. While this is a positive step, it still doesn’t point to the economy expanding overall in either the second or third quarters.

Production fell again in Germany, by 0.2% following a 0.2% rise in April. The year-on-year data shows that the economy is still struggling to make any headway, falling by 2.2% when compared to April 2022. Including EU members outside the Eurozone the fall was 1.8%.

Christine Lagarde will deliver a pre-recorded address today welcoming delegates to the ECB Conference on Eastern and Southern Europe. She will talk about the likelihood that the Central bank will need to continue to hike interest rates after the summer. She will say that any future hike will need strong reasons, but she believes that the justification is already in place.

Her views are sure to be challenged up to and beyond the next ECB meeting, but the hawks are likely to remain in the ascendancy.

Last week the euro consolidated its rise above the 1.10 level, reaching a high of 1.1245 and closed at 1.1227. It may begin to find the “air a little rarefied”, particularly if there is any chink seen in the ECB’s resolve to continue to hike rates, but for now there seems to be no stopping its advance.

Have a great day!