21 July 2022: To cut tax, or not to cut tax

GBP – Latest inflation statistics show continued increase

The battle to become the Prime Minister has entered its long final straight as Rishi Sunak and Liz Truss have become the last two candidates standing.

Both believe that they have a strong case with Sunak pointing to his record as Chancellor of the exchequer, his first Cabinet post to prove his credentials, while Truss believes that she has the strong support of the right wing of the Conservative Party.

The newspapers are building a degree of antipathy between the two into their rivalry, mostly driven by their performance at the second of the televised debates and their apparent refusal to take part in a third, apparently each fearing the other’s ability to draw them into a dogfight.

Current Prime Minister Boris Johnson attended his final Prime Minister’s questions in Parliament yesterday as he returned to the persona he had when he was first voted into the role.

Members of the Conservative Party will now be balloted and the decision on a winner will be announced on September 5th.

Early polls suggest that Truss is the early leader based upon her belief in what are considered to be traditional Conservative values, which include lowering taxes. Sunak has said that taxes will be brought down before the next General Election, but tackling rising inflation will be his first priority.

The latest inflation report was released yesterday, and it showed that the headline figure including volatile items like energy and food rose to a new high of 9.4% from 9.1% in May.

The core rate of inflation with volatile items stripped out fell from 5.9% in May to 5.8% last month. There has been some further positive news as the forecourt price of petrol has also begun to fall.

The employment report for May has also been released this week, with the claimant count falling by 20k, a much-reduced amount compared to the -34k seen in May, although the unemployment rate remains at a healthy 3.8%.

The new Prime Minister is likely to face industrial action of the 2.5 million public sector workers who have been offered a pay increase of 5% in the latest round.

That is well below the rate of inflation and is likely to be rejected. Government negotiators were hoping that the fact that any above inflation rise would simply add to inflation down the line would have an effect, but the news appears to have fallen on deaf ears.

Sterling traded in a narrow range yesterday, but remains unable to achieve a close above the 1.20 level. On the day, it fell to a low of 1.1953, closing at 1.1968 as politics weighed in what was a thin trading session.

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USD – Economic fears, a greater threat than rates currently

The overall housing market in the United States including existing home sales, new home sales and new building permits has turned lower.

Analysts believe that the series of rate hikes initiated by the Federal Reserve that is set to continue at the next meeting of the FOMC is not the main reason.

It is believed that the possibility of a recession in the economy is making potential home buyers wait until there is more certainty about the direction of economic growth.

This is an interesting theory, since there is no concern at all that any contraction of the economy will be both shallow and short-lived.

Having contracted by 1.6% in the first quarter, there remains a possibility that a technical recession will be seen once the data for Q2 is released.

That having been said, the Federal Reserve, while being accused of precipitating the slowdown by acting too hastily to lower the rate of inflation, has already stated that gaining control of rising prices is, and will remain, its priority.

Those criticising the hikes that have so far taken place have also been unable to unravel the conundrum of falling output and rising prices, which clearly remains outside the ability of the Federal Reserve.

While many have said that until there is a slowdown in the number of new jobs being created, there is no answer to rising inflation. This may indeed be true, but the cause of the continued growth in the headline rate of inflation is centred on events outside both the country and the reach of the Central Bank.

There has been a significant fall in the level of gasoline (petrol) sales in the country.

The summer months usually see a significant increase in sales, since Americans want to vacation with the U.S and think nothing of ten or even twelve-hour journeys to their various resorts.

This year there appear to have been far more local breaks being taken as the forecourt price of a gallon of fuel has risen above five dollars.

President Biden has been under pressure to reduce the Federal tax that is levied on pump sales, but has not so far made any indication of his intentions.

The dollar index continues to correct, although it may now be reaching a level at which buyers may return.

Yesterday, it rose marginally to a high of 107.25, but was unable to sustain the rise and fell back to close at 107.04.

EUR – Lagarde facing a tough time at ECB meeting

President of the ECB Christine Lagarde will have woken this morning and known that the burden she has been carrying since early in the Pandemic is about to be either lifted or made considerably heavier.

Today, Lagarde will chair the latest meeting of the Central Bank’s committee that will agree on a hike in interest rates.

On the surface, a twenty-five-basis point hike which leaves official interest rates still in negative territory, or fifty basis points which brings the rate to zero is neither here nor there.

However, the inference of the first-rate increase in over a decade will be huge.

If the hawks succeed in pushing through fifty points, it will provide a signal to the market that the ECB is serious about battling inflation, despite the much-discussed reasons for rising prices being largely out of its control.

Apparently, tools have been created that will help the more indebted nations should fifty points be agreed and the spread between their borrowing costs and those of Germany begin to widen.

This much vaunted weapon again relies on the acceptance of Germany and a few other wealthier nations of the fact that they will again find themselves guaranteeing bonds issued by Eurozone members who, in their opinion, do not have the financial discipline to manage their own economies.

In the 2012 crisis Germany extracted its pound of flesh from nations like Greece and Italy, and in the long-run, Angela Merkel’s decision has been successful, but Italy, in particular, has returned to its socialist ways of increasing pension and social security payments, as well as providing Covid-19 relief above what it can readily afford to do. This has increased its debt to GDP ratio significantly.

It is now around 140% currently, although that is lower than the 155.3 level seen in 2020. Budget deficits are now well above Brussels’ 3% limit not just in Italy but all the way along the Mediterranean coast.

Now is not the time for Brussels to reintroduce budgetary discipline, but if a repeat of 2012 is to be avoided, tools that are more effective will need to be seen.

The euro will be at the mercy of the ECB meeting today, but yesterday it managed to gain a little ground on the dollar. It rose to a high of 1.0273, but fell back to close almost unchanged at 1.0217.