20 March 2024: Interest rates and taxes are crushing the economy

The meeting of the Monetary Policy Committee that begins this morning has no “new news” to discuss. There will be a sense of relief that the “mini-recession” that started and appears to have finished at the back end of last year won’t force the Bank of England into a cut in interest rates that could be considered premature.

Nonetheless, the economy would no doubt benefit from a cut in rates, but the unpredictability of the rate of inflation demands that the Bank remains cautious.

Consumer price data will be published later this morning. It is expected to show that the rate of inflation fell to 3.6% in February, down from 4% in January. In his latest comments on inflation, the Bank’s Governor, Andrew Bailey, expressed his view that inflation only needs to show that it is on a sustainable path towards the 2% target to justify a cut in the base rate.

It remains to be seen if a fall of almost half of one percent and the lowest rate of inflation in two years is sufficient justification for a cut. There will be a lively debate, with Catherine Mann altering her stance to neutral, after a lengthy period of voting for a hike. Her vote will be matched by a call from Swati Dhingra who will vote for a cut.

The comments from the permanent members of the Committee recently have all been supportive of a cut in rates in the coming months, but there remains a hint of caution about when they should start.

On balance, they will vote for a continuation of the pause that began last September. Although Bailey didn’t define an absolute level that the rate of inflation needs to get to for a cut in rates to be justified, market sources believe that he wants to see the rate closer to 3% before “pulling the trigger”.

Producer Price data which provided a longer-term view on inflation are also due to be published today. After a significant fall in January, which led to the expectation of a substantial fall in consumer prices in February, the latest data is expected to show a slowing of “factory gate” prices.

The efficiency of supply chains means that goods arriving at wholesalers and distributors arrive at shops far faster than they have historically. This means that any supply issues quickly feed into the mainstream inflation data.

Sterling suffered a major sell-off versus the dollar in late Asian trading yesterday morning and spent the day recovering its poise. It reached a low of 1.2667 but recovered most of its losses to close marginally lower at 1.2721. Against the Euro, it also had a fairly volatile day but ended almost unchanged at 1.1707.

The advent of AI is expected to provide a significant boost to U.S. productivity over the next two or three years, but those advantages will be offset by a rise in unemployment delivered by efficiencies in the number of people needed in “traditional” industries.

Following the pandemic, the U.S. economy has adapted well to altered working practices, with the advent of home working having a negligible effect on output.

Old-style nine-to-five office jobs have been replaced with a significant improvement in workers’ work-life balance. The economy has so far adapted very well and has seen output, particularly in the services sector, improve exponentially.

The flip side of this is that there are fewer jobs available in the sector, and eventually a “tipping point” will be reached where employees that have been “repurposed” are no longer necessary.

There will need to be a restructuring of the economy to deal with this issue, which has been “turbocharged” by the economic reaction to the pandemic. It may be glib to say that the economy “always finds a way,” but unless there is considerable thought given to finding new avenues for employment, the current unemployment rate will not be seen again.

The FOMC meeting began yesterday, and Jerome Powell will address reporters later following the announcement of the result of the latest vote on interest rates.

The market is in danger of becoming a little “blasé” about the outcome of rate-setting meetings since the pause has continued for several months. The Fed retains the ability to shock markets, and it may be tempting fate to say that no change is expected later.

Recent comments from FOMC members have mostly been that further evidence is needed that inflation is firmly on a downward path for a series of cuts to be agreed.

As time moves on, the three-cut strategy that was being considered has now been changed to two cuts, although a lot will depend on the economic ratio once cuts begin.

The dollar index is still supported by the view that the Fed will be the last of the three major G7 Central banks to cut rates.

Yesterday it climbed to a high of 104.05 and closed at 103.81. It has finished higher in seven of the past eight sessions since it made a low of 102.35 on March 8th.

Although the ECB is being “tardy” in beginning a programme of rate cuts as inflation falls closer to its target of 2%, the financial markets now believe that there will be three cuts in interest rates this year.

This is an entirely feasible idea since history has shown that once the Bank has committed to a policy it tends to see it through to the end, even to the extent of overkill.

The fiscal support that was delivered to Eurozone members following the pandemic lasted one or two months too long, which delayed the start of rate increases.

The number of rate increases exceeded market expectations and went on at least a month longer than was strictly necessary, which has led to the current malaise in the economy.

The pause in rate hikes has been followed by what is an excessive pause, which has exacerbated the slack of growth seen by the economy.

An excessively dovish pivot will be considered a normal reaction from the ECB as inflation returns to its target level. The Governing Council may agree to abandon the recently agreed policy of using an average of 2% as the target and return to an absolute figure. Otherwise, they may be driven to force headline inflation well below the 2% level to meet the average.

That would be considered an economic disaster for the region and would lead to open rebellion.

An updated version of the growth and stability pact will need to be urgently considered following the start of rate cuts since several members’ debt-to-GDP ratios and budget deficits are close to being out of control.

The first quarter wage data is due for publication on May 23rd, which means it will be available for consideration at the June 6th meeting of the Governing Council. While there is no guarantee of a positive outcome for the data, this is the meeting at which a majority of market participants believe the first cut in rates will be announced.

The Euro is faced with the effect of the lack of economic activity that is plaguing the Eurozone now as well as the prospect of a cut in rates.

Yesterday, it fell to a low of 1.0823 and closed at 1.0865.

Have a great day!