1 July 2022: Bailey sees inflation longer than EU

GBP – The Governor finally faces up to reality

The Governor of the Bank of England provided a fairly downbeat summary of the inflation picture for the rest of the year, admitting that he believes that high inflation will remain a problem for the UK for significantly longer than in the Eurozone.

The reason for this assessment is that he feels that the structure of the energy price cap means that the economy will receive a further jolt in October when it is reviewed for the second time this year.

Speaking at the ECB Central Bank Symposium in Portugal, Bailey went on to say that he remains confident in the Bank’s ability to bring inflation back down to the Government’s target, a target that the Bank has missed every month since May of last year.

Bailey remains certain that inflation will peak at 11% in the Autumn, primarily due to the increase in the energy cap.

When questioned about the next MPC meeting, Bailey declined to comment on the likely action the committee will take at its next meeting.

There have been comments made by other members of the Committee, Chief Economist Huw Pill in particular, that have the markets to believe that the Bank is about to change up the tightening of monetary policy and agree to a fifty-basis point increase in early August.

The drip feed of a series of twenty-five-point increases is having no obvious effect on demand yet and has been questioned by several eminent commentators.

At the last meeting, three members of the Committee voted for fifty points and were outvoted. It is difficult to imagine what has changed so radically since then to make the other members see something that they couldn’t have seen last month to change their minds.

Every tightening of monetary policy, with a fifteen-point hike accompanied by four of twenty-five points has been met by an increase in both headline and core inflation. The first hike took place in December, which broke with a tradition of never hiking rates just before Christmas.

So, having been hiking for seven months, the Bank is no closer to defeating rising inflation. This asks whether the actions of the Bank of England have been any more successful than the ECB, which is only just about to start to tighten. If the Bank had decided to wait, it is impossible to know if the fact that the base rate would have been 100 points lower had any effect on the slowdown that has been seen in the economy, or is it simply the end of a cycle?

Thousands of variable rate mortgage payers would have seen less of an impact on their household budgets, but we will never know if that may have made it easier for them to deal with the rise in the energy price cap.

The is facing further pressure, having fallen through recent support levels. Yesterday it fell to a low of 1.2092 but managed to rally to close a little higher on the day at 1.2177 on the back of a spate of month end buying.

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USD – Powell admits to challenges, inflation concerns remain

Answering press questions in Portugal yesterday, Jerome Powell agreed that focussing on inflation could see the economy tipped into a recession. He firmly believes that it is a risk worth taking, and he remains committed to bringing inflation back to its target level.

In concert with most other developed nations, inflation is continuing to rise, unabated by any tightening of monetary policy.

Powell will continue to fight to bring down inflation, but readily acknowledges that this may be impossible since the global economy has entered a new phase as it has emerged from the Pandemic and some adjustment to expectations will need to be made.

The Fed is not the only G7 member facing this dilemma and it may be that Central banks will have to accept that the new normal includes higher core inflation, but it would be a derogation of the Bank’s duty were it not to fight rising prices.

Powell may believe that the FOMC is hampered by the fact that it can only try to reduce demand, but with a particularly tight labour market that may be impossible to achieve.

The belief that the continued hiking of interest rates will lead to a recession is based on the core values guiding the economy since the financial crisis.

The truth is that no one can now say for certain that rising interest rates will slow the economy to such an effect that output and activity will slip into contraction.

The FOMC remains sufficiently hawkish to agree to a further seventy-five-point hike in interest rates. The issue that traders have is that if they hike by another seventy-five points this month and inflation continues to rise, will the next hike be a full one percent?

It may be that there will be calls for the hikes to be suspended soon to allow the economy to catch up. However, it is unlikely that the hawks will agree to hat given their apparent quest to bring inflation under control

Given the new global paradigm, the question will need to be asked if the current target is going to actually be achievable given the shift in the global economy.

Yesterday, the dollar index rallied to a high of 105.54, but ran into some quite aggressive selling interest. It fell back rapidly to close at 104.69. While traders are happy to say that they see the dollar rallying in the second half of the year, it may be too soon for that to happen as the picture remains unclear.

EUR – H2 begins with the ECB in the mood to fight inflation

We appear to have finally reached the point where the ECB is prepared to join with other G7 nations and begin to hike interest rates to fight inflation.

However, as has already been discussed, does Christine Lagarde deserve criticism or praise for having managed to deter the hawks on the Governing Council from voting to hike much sooner.

All economies are different and have different drivers, and it is possible that the effect of a hike on several of the heavily indebted nations would have seen them already in recession.

There will be questions asked about why the effect of the withdrawal of support wasn’t better predicted, since it has now led to the fragmentation that has been created.

It is fairly clear that having been the virtual sole provider of liquidity to the Government Bond Market, to suddenly pull the rug has had a significant effect.

For example, issuance from Italy yesterday saw them forced to pat rates that have not been seen since the onset of the financial crisis.

This will undoubtedly see the question of one size fitting all raised again, and yet again will lead to the more affluent nations being called upon to bail out the rest.

It may very well be that the conflict in Ukraine will strengthen the political will for the European Union to continue as it is. There will be some natural progression as the Union matures but there are very few rumblings, if any, about the benefit of remaining a member.

The ECB will meet on the 21st July and following this, Christine Lagarde will announce the outcome of the vote on monetary policy. Lagarde has asked that members of the Council refrain from commenting on the decision for at least forty-eight hours to allow markets to digest the hike.

This may be difficult for those who believe that the decision was wrong. The dove will be even more concerned about recession if the hike is fifty basis points, while the hawks will see control of inflation remaining impossible if the hike is twenty-five.

Yesterday, the euro saw a precipitous fall to a low of 1.0382, but it managed to recover to close at 1.0483 as short positions were closed.