22 May 2023: Inflation to fall quicker than wages

Bank of England Governor, Andrew Bailey, attended a conference in the U.S. in which the amount of advance guidance that is given to the markets of Central Bank monetary policy intentions was discussed.

Over several years, and even up until very recently. There was little market interest in what the Bank was doing since inflation was low for several years, so interest rates were allowed to fall, then over the past eighteen months, as prices of energy and foodstuffs have skyrocketed, tightening of policy has been both necessary and obvious.

At the margin of policy changes, as the Bank is either beginning or ending policy changes, is when the advance guidance to the market needs to be considered.

During the cycle of rate increases, only the increments are of interest to analysts and investors, since as inflation continues to rise, a hike becomes a foregone conclusion.

The G7 nations which met in Japan last week, are all arriving at an inflection point in policy changes where the markets are expecting them to call a halt to further increases.

In retrospect, Bailey’s comments made last week were more indicative than was realized at the time. He warned that as headline inflation fell, there remains an issue of a wage/price spiral, where workers have demanded and sometimes received, in some cases, double-digit wage increases to stave off the effects of the rise in the cost of living.

This week, the April inflation report will be published and it is expected to show a significant fall as the drop in wholesale energy prices is factored into the data.

Clearly, there is a lag between price and wages. By the time salary increases have been negotiated, agreed and then paid to workers, the level of inflation has often peaked, leaving employers needing to recoup wage settlements in the cost of their goods and services.

The wage increases lead to core inflation remaining high while the costs that are passed on slow the fall in the headline.

This has led to the cautious note in Bailey’s comments last week in which despite the expected fall in April’s headline rate of inflation since the country may now be entering a spiral which may take several months to recede.

The data which will be released on Wednesday, is expected to show that headline inflation has fallen to 8.2% year on year, down from 10.1% seen in March.

Another piece of good news will be the release of the Government’s borrowings, which are expected to have fallen from over £20 billion to around £8.75 billion as fuel cap payments recede.

Last week Sterling stabilized after its fall against the dollar the previous week, although it remains in an uptrend. It was virtually unchanged at 1.2446.

Jerome Powell, the Chairman of the Federal Reserve made a speech last week, which could be labelled as “cautiously dovish”.

He spoke of the effect of the expected credit crunch due to recent bank failures and said that the Central Bank may not be in a position to raise rates by as much as the market may expect.

The FOMC may need to forego further rise(s) in short-term rates, while the resilience of interbank lending is quantified.

The collapse of Silicon Valley Bank and two other lenders is still being felt by other financial institutions and an evaluation of the knock-on effect on hiring and growth and inflation is taking place. He went on to say that it is not just the headline numbers that lead to the bank being data-dependent, but secondary factors that need greater interpretation.

As a result of this, Powell feels that a period of circumspection may be necessary which may lead to rates not needing to rise as much as the market expects in order for the Fed to achieve its goals.

The debate over whether the FOMC will hike rates for an eleventh straight meeting continues and appears to have become regionally based as the concerns over a coming recession and continued price increases is affecting some areas of the country more than others.

Since March of 2022, the Fed has raised interest rates by 500 basis points, an increase Powell described as “notable”.

There is still a lag between cause and effect, with the additional credit stresses now having to be factored in as well. This may well lead to a degree of prudence from the Central Bank but it won’t hesitate to resume rate hikes should the situation demand it.

This week will see the release of preliminary output data for the manufacturing and services sectors, as well as conglomerate figures.

Both individual numbers are likely to continue in an expansive phase, although manufacturing output remains very close to the watershed level between contraction expansion.

Last week, the dollar index moved further away from its medium-term support level. It rose to a high of 103.62 and closed at 103.19. If it is to maintain its momentum, it faces a challenge to break through the 104.60 level, which marks the short-term target.

Several members of the ECB’s rate-setting Governing Council who could be considered dovish, have spoken recently of the cycle of rate hikes nearing its end.

The next consideration will be how long rates will need to remain “elevated” before the economy reaches a point where it needs the assistance of lower interest rates to stimulate demand and growth.

The popular view is that the Central Bank will likely hike twice more, each time by twenty-five basis points bringing the marginal lending rate to 4.25%.

In the words of ECB President, Christine Lagarde, inflation remains “sticky”, driving her more hawkish colleagues to feel that inflation has not yet been defeated. The headline actually rose to 7% last month. Although that was due to a series of one-off events, the data cannot be ignored.

According to Luis de Guingos, Governor of the Bank of Spain, most of the rate hikes have taken place, and although he remains rooted in the “dovish camp”, he remains concerned about the rise in the services sector.

This reflects the secondary effect of the rise in energy prices but more importantly rising wages.

Employment in the Eurozone remains buoyant. Not at the level seen in the U.S. but vacancies still remain plentiful and rate increases have not, as yet, had the dampening effect that may have been expected to be seen.

De Guingos won’t be drawn on his view of the end-point in rate hike but he did intimate that the market has the right idea.

This week, the composite data for manufacturing and services output will be published. It is likely to show continued expansion, easing slightly from 54.1 to 53.7.

Later in the week, the final cut of German Q1 GDP will be released, accompanied by a speech from Bundesbank President Joachim Nagel.

Last week, the euro fell to a low of 1.0753 and closed at 1.0803 as the 1.10 level looks some distance away.

Have a great day!