23 June 2022: Central Bank risking credibility

GBP – Monetary policy stuck between growth and inflation

Data published yesterday confirmed that headline inflation in the UK continues to rise, but the rate of increase may be slowing.

The consumer price index rose by 9.1% year-on-year in May, following a rise of 9% in April.

In her speech earlier this week MPC member Catherine Mann argued that every one percent rise in U.S. interest rates will see the pound devalued by 4.5% over a two-year period, and add 0.5% to UK inflation.

Given that the Federal Reserve is committed to continuing to hike rates in ever larger increments, the Bank may need to keep pace unless it decides that any support for the pound would be futile given the still painful memories of 1992.

In what looks like becoming an ongoing discussion, the Bank of England’s Chief Economist disputed Mann’s claim, commenting that raising interest rates at a faster rate wouldn’t help Sterling.

Huw Pill argues that rate hikes will support Sterling in any event, and they don’t need to become more aggressive in hiking rates unless it is warranted in order to bring inflation back to a more acceptable level.

The fact remains that rising inflation globally is being driven by factors that won’t necessarily go away if official interest rates continue to rise.

The UK has been hit by a perfect storm as the Central bank tries to return monetary policy to normal.

The Fact that rates have been at levels that are lower than they have ever been historically surely means that this is the new normal for early in the 21st century.

The need is for the Bank of England is more flexibility and a real investigation into exactly what tools it needs to drive the economy forward, rather than always being reactive to the situation it faces.

The perfect storm is the balance that needs to be struck between inflation and economic contraction, both of which are affecting the economy at the same time, which is a unique phenomenon.

Pill believes that in today’s markets, it would be a distraction to make the pound any kind of focus, unless it became seriously out of line and was trading at an unnatural level. Pill is harking back to John Major’s Government, which in 1992 tried to maintain the level of the pound versus the Deutschmark, and was in the end forced to bow to market forces.

The discussion about the size of the next interest rate hike will continue until the next MPC meeting, with the case for either twenty-five or fifty basis points receiving equal support.

Yesterday, the pound saw increased volatility but closed almost exactly where it started. It traded between 1.2314 and 1.2161, closing at 1.2266, six pips lower on the day.

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USD – Fed to continue to hike rates

Jerome Powell tried to take congress back to school yesterday as he explained to its members, who are not in necessity supportive of the monetary policy he and his FOMC colleagues are pursuing.

Powell explained a useful fact that should be heeded by central bankers and politicians globally. No matter how fast interest rates are hiked, they will not bring down the price of groceries or a gallon of petrol immediately. The Fed is concentrating on demand in hiking interest rates, since it is unable to influence supply for now.

The tools at the Central bank’s disposal can only affect demand, and that is where concentration is focussed.

Recent data for existing home sales showed that demand for homes is being affected, and this is often the first sign of a slowdown in demand.

It is inflation that hits what a household can spend on a weekly basis on foodstuffs and items such as social activity, but the decision to move house even if it is a far larger commitment is made relatively easy when the cost of the new property has been rising and now the cost of a new home loan becomes prohibitive.

Powell remains an inflation hawk, having had his fingers badly burned in trying to dismiss the fracture that was occurring between supply and demand as the economy emerged from the Pandemic.

The relative tightness of the economy is a further factor. Workers remain in demand and although new job creation as seen in the NFP data is made up of job hoppers, moving for a higher salary, applications for jobless benefits have remained fairly constant recently at +/- 10% from 200k.

Powell went on to say that the economy is under threat of recession for the next four quarters, but that is not his baseline consideration, although achieving a soft landing is becoming more of a challenge.

While the FOMC discusses the size of interest rate hikes at its meetings and there are some strong opinions from its members, Powell himself will not remove the possibility of any size of hike from the table.

Two of Powell’s FOMC colleagues, Charles Evans from Chicago, and Patrick Harker from Philadelphia, both spoke yesterday of the need for higher rates. Evans believes that rates need to rise for some months to come, while Harker expects the Fed Funds to be at least 3% by year-end.

The dollar index was underwhelmed by the Fed Chairman’s comments, since he said nothing that hadn’t been heard before. The balance between contraction and inflation is delicate, and the jury is out whether it can be achieved using current policy.

It traded between 104.94 and 103.86, and closed marginally lower at 104.21.

EUR – Fragmentation set to grow unless ECB acts

Consumer confidence showed just how fragile it is within the Eurozone yesterday. Having risen ever slightly in May, the data for June showed that it fell from -21.2 to -23.6.

While it can be argued that the size of the negativity at these levels is fairly immaterial, the fact that it is possible to deteriorate even from here is disappointing, even if it is understandable.

The fact that the long-term average for consumer confidence in the region hovers between -10 and -11 speaks of the issues that the Union continues to face.

The price of food is skyrocketing, energy bills are rising exponentially, and the war in Ukraine shows no sign of abating.

The whole of Europe is facing cuts in supply of Russian gas as the aggressors in the war try to counter sanctions by creating hardship for its neighbours.

The latest bombshell to hit Christine Lagarde, who is still clinging to the belief that she can defeat the hawks on the rate-setting committee, and stick to her promise of a twenty-five-basis point hike and next month’s meeting, is the issue of fragmentation.

This is the spread that is being charged by lenders to indebted members of the Eurozone.

It seems that banks want material evidence that the ECB is prepared to stand behind indebted nations, as a lender of last resort should they get into difficulties.

Membership of the Eurozone is no longer sufficient, although in reality, no nation that has the euro as its currency could be allowed to fail. It may be that the reinvestment of PEPP maturities back into the bonds of weaker economies may become semi-permanent.

As a tool at the disposal of the Central Bank, this should be used in emergencies, not to provide succour to those countries who fail to meet the financial discipline that the stronger nations practice.

The euro remains fairly directionless. It rose to a high of 1.0605 yesterday but fell back to close at 1.0567.