19 December 2024: Just how healthy is the economy?

Highlights

  • Inflation rise in November means that rates will remain unchanged
  • The Fed cuts rates, but the next cut is anyone’s guess
  • ECB to publish crucial wage data following its meetings
GBP – Market Commentary

Inflation leaves Bailey in a difficult position

Today’s meeting of the Monetary Policy Committee was rendered superfluous by the latest inflation data published yesterday.

In November, headline inflation rose to 2.6% year-on-year, from 2.3%. Meanwhile, core inflation rose from 3.3% to 3.6%.

While this was in line with analyst’s expectations, it will have come as a blow to anyone who was hoping for a festive cut in interest rates. Inflation has now risen for two consecutive months, which will leave the MPC scratching its collective head since they have cut interest rates at a time when inflation is not under control.

Persistent inflation in the services sector, the dominant part of the U.K. economy, had led money markets to price in almost no chance of an interest rate cut during the Bank of England’s final meeting of the year today. Those bets were solidified earlier this week when the ONS reported that regular wage growth strengthened to 5.2% over the August to October period, up from 4.9% over the previous three months.

Last month, services inflation was unchanged at 5%.

It is now likely that the MPC will leave rates on hold for at least the entire first quarter of the New Year, prompting mention of dreaded “stagflation,” as inflation rises and growth falls.

The economy has stalled recently, possibly going back to the summer, while prices indicate that the cost-of-living crisis is far from over.

Having already alienated pensioners by making changes to the Winter Fuel Allowance in the Budget, Rachel Reeves has “poured salt on the wound” by refusing to reconsider the decision to not provide compensation to women who were caught unaware that the government was going to change their state retirement age.

This has left three million women with a “black hole” of around ten thousand pounds in their pension. Women born in the 1950s have said they were not given sufficient notice the pension age was rising from 60 to 65 in the 2010s, with an ombudsman recommending they receive up to £2,950 in compensation.

The government revealed on Tuesday it would not be compensating millions of women born in the 1950s, known as Waspi women (Women Against State Pension Inequality)

The government said the ombudsman found 90% of affected women knew about the changes, so there was no reason to compensate them at an estimated £10.5bn, with Sir Keir commenting during Prime Minister’s Questions: “The taxpayers simply can’t afford the burden.”

Economists are fearing the worst for the economy as confidence has taken a severe battering due to the rise in tax that was also introduced during the Budget, With the rise in employer’s national insurance beginning next April, firms of all sizes are reconsidering their investment plans with the majority planning to scale back while adopting a wait-and-see policy.

The pound saw a significant fall late in the day as the FOMC announced that rates would be cut, but any future cuts would be held back since inflation is still not controlled.

The FOMC has the luxury of being able to “temper” any dovish tendencies since the U.S. economy is still robust, a luxury the MPC does not have.

Sterling fell to a low of 1.2562 and closed at 1.2572.

USD – Market Commentary

Fed to slow pace of rate cuts in 2025

The FOMC seems to have got itself into something of a tangle.

By cutting rates when there was no need for cuts given the robustness of the U.S. economy, it has convinced the markets that those cuts were necessary since they were being proactive in their actions.

The issue started when the Committee voted for a fifty-point cut in September, fearing that the employment data would show significant weakness. This weakness didn’t materialize, leaving several Committee members regretting their actions.

Yesterday’s rate cut also appears to be unwarranted, since inflation has picked up again recently while the economy is performing more than adequately.

The market is terming yesterday’s rate cut a “hawkish cut”. This is a term, like a “dovish hike”, which tends to be used at the end of a policy cycle.

The Fed is far from the end of its cycle of rate cuts and is now faced with a long pause which has seen asset markets tumble, while the dollar received a significant boost.

The Federal Reserve slashed the fed rates from 4.50% to 4.25% on Wednesday. However, its Chair, Jerome Powell, said that further rate cuts in 2025 would depend on inflation. The statement is seen as a clear-cut indication that further rate cuts under Trump’s administration would only be possible if there is enough progress in tackling surging inflation.

Powell has repeatedly urged caution while lowering rates. The looming threat of higher inflation shook Wall Street, causing stocks to drop sharply, bond yields to rise, and prompting investors to lower their expectations for how much borrowing costs might decline in the coming year.

“I think we’re in a good place, but I think from here it’s a new phase, and we’re going to be cautious about further cuts,” Powell said at a press conference after the Central Bank’s policy-setting Federal Open Market Committee cut its benchmark interest rate by a quarter of a percentage point at the end of a two-day meeting.

Powell further pointed out that inflation has improved after reaching its peak in 2022 but has gone “sideways” in recent months.

Before the December meeting, US financial markets had been drunk on rate-cut euphoria over the last three months. However, the Grinch arrived early to steal Wall Street’s Christmas this year.

The Fed faces issues going forward into 2025, but they differ from those faced by the ECB and now the Bank of England.

It has been the architect of its problems, having ignored the fact that cutting rates during a time of robust growth is a recipe for fuelling inflation.

Were Jerome Powell and the rest of the FOMC blindsided by the election result? despite saying that they were not “politically motivated.”

They will now have to reap what they sow and hope that inflation begins to fall in the coming months since the alternative (a hike in rates) is too awful to contemplate.

The dollar rose following Powell’s news conference, reaching a high of 108.27 and closing at 108.24. The 110 level is now well within its sights but may have to wait for the New Year, and Trump’s inauguration, to be realized.

EUR – Market Commentary

Next year will likely see economic and political headwinds

The divergence between monetary policy in the U.S. and Eurozone is now a glaring reality. While Isabel Schnabel and her hawkish colleagues on the ECB’s Governing Council call for rate cuts to be moderated, which is unlikely to be heeded, the FOMC has called a halt to loosening monetary policy for the time being.

A surge in market pressure on France due to concern over its budget deficit has been “limited” and part of the normal functioning of Eurozone bond markets, the European Central Bank’s chief economist Philip Lane said yesterday.

A series of political crises this year has rattled investors in French government bonds and brought the country’s budget problems to the fore, with the premium that buyers demand to own French bonds rising to the highest level since a debt crisis 12 years ago.

New French Prime Minister Francois Bayrou said upon his appointment last week that he faced a “Himalayan” challenge to tackle France’s deficit, which he said was a moral and not just financial question.

Europe faces economic and political headwinds next year, including, potential tariffs on its exports to the U.S. high energy prices, more competition from China and elections in France and Germany, among others.

Against this backdrop, the ECB may have to refocus its sights on rising inflation despite any possible recession in the twenty-country union.

An actual recession in the eurozone is unlikely. Just slow and uneven growth ahead in 2025. Business sentiment across the bloc is negative, the same applies to consumer sentiment, despite rising wages.

Inflation is still higher than it should be, which is due primarily to the services sector, where output and growth remain healthy.

The return of Syrian refugees to their country could have negative consequences for the German economy and create problems for areas where there is a shortage of workers, a report published yesterday shows.

There are currently around 80,000 Syrians in positions where there is a shortage of workers, such as car mechanics, doctors, dentists and workers who deal with heating and cooling equipment, according to a study by the German Economic Institute in Cologne.

In the automotive sector, there are more than 4,000 people who currently work as mechanics in areas where almost 70% of the positions cannot be filled by qualified professionals, the analysis says. While the automotive sector is looking to shed jobs, these skilled positions are vital to the sector’s viability.

Inflation has been easing, but its path lower has been anything but a straight line, prompting hawks to call for less advance guidance of the ECB’s intentions.

The pace of the precipitous fall in the value of the Euro yesterday will slow, but it is on a clear downward path, which will make imports more expensive and while a cheaper Euro may offset some of the cost of the tariffs Donald Trump is threatening to introduce.

Following yesterday’s FOMC meeting, the euro fell to a low of 1.0344 and closed at 1.0365. The last time it was at this level, it saw support at 1.0290 which delayed its fall but is still eventually traded through parity.

Have a great day!

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Alan Hill

Alan has been involved in the FX market for more than 25 years and brings a wealth of experience to his content. His knowledge has been gained while trading through some of the most volatile periods of recent history. His commentary relies on an understanding of past events and how they will affect future market performance.