21 July 2023: Bank of England may rue “what might have been”

This week’s publication of inflation data for June illustrated how much more the Bank of England could have done had it not been timid about the effect its actions could have had on the economy.

The Bank and the Treasury have not worked in tandem to bring inflation lower, and it is as if the two agencies do not talk to each other.

There is little question that the actions of the Chancellor, Rishi Sunak, planted the seeds that eventually grew into the highest rate of inflation in a generation, but the Bank of England has lacked the courage seen in other G7 nations to “take the bull by the horns” and tighten monetary policy significantly faster than it has.

Now, with inflation beginning to retreat, due in part to their most recent action in hiking rates by fifty basis points, they are left wondering if they could have been more aggressive.

In the seventies and early eighties, it was said of the economy, which was plagued by industrial action which made union leaders into TV celebrities, that the UK suffered from a malaise which emanated from a nation living in the past and trying to repeat the energy created by the post-war years.

The “Thatcher years” put paid to union militancy, but the country is now suffering from a similar weakness of Government that happened in the seventies, although at that time, the country was ruled by the Labour Party, which was on its “last legs.”

At that time, there were arguments about whether the country was strong enough to be able to go it alone without joining into what was then called the common market.

That argument still exists, and although the common market is now called the European Union, the UK, having joined and left, is still pondering if it is able, in the modern world, to flourish without the trade benefits that membership of the single market affords it.

Inflation will continue to fall since it is clearly cyclical in nature, but the efforts of the Monetary Policy Committee may have been for nothing if they leave the country with a rate of inflation that is still well above the Government’s 2% target and an economy that remains unable to deliver growth that is anything other than meagre at next.

It may well be that the country needs the support that a change of Government will bring, but the Labour Party, having been in opposition, may not be able to be anything other than different.

They are yet to suggest any radical changes that they would bring, and with the current debt to GDP ratio already at 100%, a programme that involves now borrowing, whether it is fully costed or not, could see the country stagnate and forfeit the benefits, however fleeting that Brexit may have brought.

Since the present Government has said it will not lower taxes to try to make up the deficit it has in opinion polls, the next year will have a significant effect on the country which could last for the next decade.

The pound has continued the slide which began following the release of the June inflation report. Yesterday, it fell to a low of 1.2838 and closed at 1.2867.

Finally, after a fifteen-month battle, the Federal Reserve is close to being able to declare victory over inflation, which has been a difficult foe. Even now, it is understood that the Chair of the Fed, Jerome Powell, wants to hike rates once more to ensure that not only inflation doesn’t return in the short-term but is almost eradicated from the economy.

That is a tall, if not impossible order, since no one can predict what unexpected events may cause the treasury to provide the level of support that was provided during and in the immediate aftermath of the Pandemic.

Even now, with inflation close to the Fed’s target of 2%, there are still questions being raised about the Fed’s actions, but they are not asking if a soft landing can be achieved, but whether, even at this point, the economy can avoid a recession.

Even those who were not aware of the inversion of the yield curve are suddenly asking questions about what the Fed could have done differently.

The FOMC meeting that will take place next week is still expected to sanction a further hike in the fed funds rate, but then there will be a gap until the next meeting, which will not be held until September 20th.

That should allow Powell to provide sufficient time, having had the benefit of two months of data, to provide advance guidance that gives a strong clue that the cycle of rate hikes is over.

Of course, that could happen next week if there are sufficient doubts raised about the hike that is proposed then.

The concerns regarding a recession emanate, as already mentioned from the inversion of the yield curve, but that is not the only indicator currently pointing to a contraction of the economy.

The Leading Economic indicator index, which was released by the Conference Board this week, fell for its fifteenth consecutive month, coincidentally the same period over which the Fed has been raising rates.

Most banks are now issuing investor briefings that do not include a recession as their expected outcome, and since they are close to their customers’ intentions, they may be a more reliable indicator.

The dollar index has rebounded from its recent correction and is expected to end the week higher than it started. Yesterday, it rose to a high of 100.97 and closed at 100.83. After next week’s FOMC meeting, both activity and liquidity may be expected to fall as traders and investors on both sides of the Atlantic begin their annual holidays.

Joachim Nagel, the President of the Bundesbank, took some time away from cajoling his colleagues on the Governing Council of the ECB regarding further interest rate hikes, to lambast the German Federal Government for the amount of fiscal support that it provided during, and in the immediate aftermath of the Pandemic to its citizens.

Germans who are not used to receiving handouts from the Government became used to spending, which pushed demand well above supply and led to a rate of inflation that made the Central Bank “uncomfortable.”

He went on to say that the time has come to “reassess” the measures that successive Governments have unveiled during the pandemic and Russia’s invasion of Ukraine.

While the support was doubtless necessary at the time, it should now be tempered to allow the economy to return to a “truer picture” of its health.

Elsewhere, questions are still being asked about the outcome of next week’s ECB rate-setting meeting. Yesterday, it was the turn of the Governor of the Bank of Greece, Yannis Stournaras, to ask if the time has come for the ECB to end its cycle of rate hikes.

Stournaras, who has presided over something of an economic miracle by bringing Greek Government Bonds back to investment-grade status, is in favour of a hike next week but feels that any further hikes could begin to damage the economy.

No one doubts that inflation will remain above target until the end of 2025, but given what the economy has been through since 2020, there is bound to be some overhang.

It is important that the ECB is mindful of the needs of all its members, considering cyclical factors, as well as those created by the support that was provided by necessity during the pandemic.

Next week, the wait will finally be over, and it will be beholden upon Christine Lagarde to provide sufficient advance guidance in her address following the meeting to allow traders and investors to have a little assurance about the outcome of the September meeting.

It is now clear that the recent rise in the value of the common currency was more to do with dollar weakness rather than any significant strength being attributed to the euro.

Yesterday, it completed a major “top”, falling to a low of 1.1118 and closing at 1.1129.

Next week’s Central Bank meetings will set the tone for the Summer as both the Fed and ECB pause the meetings until September.

Have a great day!