Rising energy costs to drive inflation higher for longer

As the recovery from the Coronavirus outbreak has begun, Bank of England Governor, Andrew Bailey, has been confident that the rise in inflation that has gripped most developed economies is simply a reaction to the level of support being provided.

This theory is about to be severely tested as the wholesale price of gas continues to rise. This is fed through into UK households in the shape of higher fuel costs and is also having a knock-on effect on other energy sectors, in particular, the price of oil.

Petrol prices are already significantly higher. The pump price of standard unleaded petrol is now above £1.40 per litre.

Bailey is beginning to feel the pinch and is concerned that the Central Bank will have to act to curtail what could fast become a major crisis for the recovery.

Raising short-term interest rates to curtail rising inflation would be a fairly drastic measure, but the MPC may be left with no choice.

Bailey believes that even the rise in fuel prices is a passing threat, and he went on to say in a recent interview that monetary policy cannot be used to solve supply-side issues.

A rise in rates will have a dampening effect on several areas of the economy, not least, property sales.

While the housing market is suffering from several structural issues concerning supply, there were fears that a bubble was beginning to form, but this would certainly burst should interest rates begin to rise.

Inflation data is due to be released on Wednesday, with the headline number for CPI closing in on 4%.

With the next MPC meeting to be held on 4th November, there is now a real possibility that the Bank of England will be under pressure to act.

Sterling rose last week on the back of interest rate expectations. This coincided with a correction in the dollar index that is considered temporary.

Meanwhile, this could be a significant week for the medium-term fate of the pound.

Last week, it reached a high of 1.3773, closing at 1.3743.

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November looks likely to be the start of return to normal

The race to begin to withdraw support for economies hit by the Coronavirus Pandemic has begun in earnest, with the Federal Reserve now seen as likely to begin to taper asset purchases at its next meeting.

That will take place on November second and, which means that the market will be gearing up for a major shift in policy globally, since a move by the U.S. will precipitate changes elsewhere.

Several regional Fed Presidents have spoken of the distinction that should be made between the withdrawal of asset purchases that should be considered a reaction to the recovery and rising interest rates that are currently not seen as necessary.

The FOMC will be keen to see the effect the withdrawal of emergency support has on inflation before any consideration is given to tightening monetary policy further by raising interest rates.

The unprecedented level of liquidity pumped into the market has driven equity prices to much higher levels than are merited by the economy. Although growth is likely to be significantly higher this year, it must be remembered that it is coming off a historic short-term recession created by the lockdowns.

The top five U.S. investment banks made additional profits of over $50 billion through 2020 and so far in 2021 compared to comparable pre-Covid periods as the volatility seen in financial markets exploded.

The FOMC appears to still have sufficient control over the market to be able to go at its own pace, but with inflation rising to levels not seen in a decade, that window of opportunity is beginning to close.

As mentioned above, the dollar index appears to be in a shallow correction, with a bottom likely to be around 93.40/50. Last week it reached a low of 93.76, closing at 93.95 Rising volatility is expected to remain at least for the rest of this month and the first week of November as Central Banks prepare to act to curb inflation.

Lagarde insists inflation is a transitory issue (again)

Not for the first time, the ECB appears to be out of step with other G7 Central Banks.

Like the boy who cried wolf, the ECB President is continuing to label rising inflation as a transitory issue. While that may be so, the more hawkish Eurozone members are entitled to begin to ask if she believes the term transitory to be time bound.

While the ECB is responsible for creating low inflation growth for the entire Eurozone, its policies may be too much of a good thing for certain economies, while being only just sufficient to stave off recession in others.

The German economy is certainly on the too much of a good thing side of the current level of support, with headline inflation now above 4%.

Lagarde is determined that the economy won’t fall into the trap of changing monetary policy before it has had the maximum effect. This is something that has happened before and has led to economic uncertainty in the past.

The current level of support created by asset purchases is unlikely to be changed before the end of Q1 next year. That is when the current round of support expires.

Lagarde has already confirmed that fresh support will be available, since the Central Bank has agreed to create a semi-permanent support system that will not need approval before implementation.

There is likely to be some tense negotiation between Frankfurt and Brussels as fiscal policy, controlled by individual nations, is brought into line with monetary policy, which is centrally decided.

The term fiscal discipline, a favourite of the Bundesbank, has been virtually abandoned during the Pandemic, and it will require a major effort and possible more sacrifice if it is to return.

The fact that the ECB is out of line with the Bank of England and Federal Reserve means that the recent rise in the value of the euro is likely to be temporary.

Last week it rose to a high of 1.1624, closing at 1.1601.