19 October 2023: Rising inflation is not an “overnight” fix

The rate of inflation was unchanged in September with the headline rate remaining at 6.7%, while the core rate with volatile items like food and energy stripped out stood at 6.1%, a fall of 0.1%.

Given the fact that the current cycle of interest rate increases has now lasted seven quarters, the current data is expected to provide the Bank of England with sufficient leeway to continue the pause in rate increases that began last month.

History will tell whether the course of action adopted by the MPC in raising rates by twenty-five basis points over an extended period was sufficiently aggressive to combat rising inflation, but at the time there was genuine concern that any larger incremental increase would drive the economy into recession.

With hindsight and considering where the economy is now, it may have been more practical to combat rising inflation with a more aggressive approach.

Now the situation essentially remains the same. The current level of inflation is well above the average over the past twenty-five years, and while it may be considered glib to believe that inflation is falling with the current rate of interest that the risk of causing a deep recession, is too great for any further hikes to be considered.

It is likely a coincidence that since the MPC was created in 1993 inflation has remained below its historical average.

The nature of the global economic cycle is that there are periodic shocks that shape the growth/inflation picture like the oil price turmoil that saw the price of a barrel of oil quadruple from $3 per barrel to $12 per barrel.

The global reaction to the Pandemic where liquidity and support was pumped into every developed economy has had a similar effect, and it is maybe too much to expect the Bank of England to use its solitary available tactic to drive the inflation that has been created back to its previous level in such a short time.

The legacy of the Pandemic will remain a factor for several years to come, just as the world got used to a significantly higher oil price.

The independence of the Bank of England is now “set in stone”, and while it is now above the political machinations of an election year, it would not be in the Government’s, or indeed the country’s best interests to see a recession in an election year.

The data this week has marginally shifted the odds on a further pause in interest rates but is unlikely to allow Andrew Bailey to announce the end of the cycle. Furthermore, there is little point in announcing the end of the cycle when there is growing uncertainty surrounding the global economy.

Sterling fell to a low of 1.2127 yesterday as the dollar reasserted itself. It closed just two points from the low at 1.2129.

There are far more drivers in play that will affect the U.S. economy than the state of the employment market and the rate of inflation, to allow the FOMC to make “intelligent” judgments on whether to return to its cycle of rate hikes at its next meeting which takes place early next month.

Chicago Fed President Austen Goolsbee has risen in prominence over the past six months. He took over as President of the Chicago Fed in January but has a long association with the Council of Economic advisers as a member since 2001 and its chairman between 2009 and 2011.

He has the credentials to speak on the longer-term effects of the rise in interest rates that the FOMC embarked upon eighteen months ago.

While rates are driven primarily by national events which are within the scope of the Fed, such is the reach of the U.S. that some credence must be given to global events.

The chain of rate hikes has not had a material effect on the employment market which has produced two million new jobs this year alone. There is a so far unclear or unconsidered driver that is keeping employment data buoyant and keeping inflation high.

It has been many years since the Fed was driven to raise interest rates by such a degree moving from almost zero to the current target of 5.25% to 5.50%.

The Fed’s economists have been a powerful influence in the background and recently announced that they are confident that the economy will not face a recession this year or next.

American consumers always come to the aid of a faltering economy, but it would be foolhardy for the FOMC to blindly hike rates two or three more times to crush inflation relying on retail sales to remain healthy and avoid a recession.

The market is still using wishful thinking to decide its view on Fed actions, simply believing that after eighteen months rates must be close to their peak. While that is true, a more scientific approach which considers more “current” factors like the export of the country’s manufacturing capability and the rise of AI, have to be factored into current thinking.

This week, the dollar has been driven by tensions in the Middle East as the President has tried to stop the conflict in Israel from becoming a regional war.

Yesterday, the dollar index climbed to the top of its recent range but is still hemmed in by a mix of national and international factors. It rose to a high of 106.63 and closed at 106.56.

With most significant data for September now known the market will likely be driven by events in the Middle East until speculation begins over any possible change in monetary policy at the forthcoming FOMC meeting.

When global tensions rise as are being seen currently, the European Union splits into its composite parts as national leaders take on the role of diplomats.

Despite a significant flare up in Brussels this week that involved a terrorist event, it is left to the French and German heads of state to represent the EU, visiting the Middle East to try to calm the situation while expressing their support for Israel.

The EU is stuck in a delicate position. It has ambition to be a global force but is unable to break free of the shackles of being considered little more than a trading bloc.

This is the opposite of the UK which sees itself as a global power but has little more than its historical relevance to support that view.

It will be years, if at all, before the European Union earns a seat at the top table and to achieve that it must speak with one voice over matters that affect the global situation outside the economy.

Inflation data was published yesterday and despite another rate increase at the ECB’s latest meeting both the headline and core rates were unchanged at 4.5% and 4.3% respectively.

This appears to bear out the comments by Christine Lagarde recently that until wage increase are brought under closer control inflation will remain high.

Given the EU’s lack of any great historical reference points it is working in the dark to a substantial extent, not having a method of gauging how significant global events such as have happened over the past ten years and are currently driving the global economy would have affected it.

Interest rates are the only tool available to the Central Bank, since it is unable to rely on fiscal decisions that are taken at an individual member level with no cohesion as to timing or reasoning.

For example, there is little or no correlation between what Germany delivers socially for its people compared to Italy. In fact, their fiscal policy may even have the exact opposite effect on the overall Eurozone economy.

The ECB’s next meeting is unlikely to be driven to change its view of monetary policy with nothing in the data, or the comments from Governing Council Members that make the market expect anything other than another twenty-five-basis point increase.

The Euro continues to “bob around like a cork caught on the tide”. Yesterday, it fell to a low of 1.0523, closing at 1.0536.

It is still gleaning a degree of support from rate expectations and will continue to do so until the ECB decides that enough is enough. It will then be left at the mercy of the economy when its true value may be considered.

Have a great day!