24 May 2022: Inflation is stalling growth

Governor studying appropriate degree of tightening

Andrew Bailey admitted when speaking at a conference in Vienna yesterday that the cost-of-living crisis is driving the UK into recession.

He agreed with a questioner who commented that the effect on real wages of rising inflation is bound to hit demand.

However, he refused to believe that the fact that the Central bank failed to respond quickly enough initially drove demand higher and therefore stoked inflation. He went on to say that one of the primary discussions at the Monetary Policy Committee when agreeing the necessary level of tightening revolves around demand and balancing that with bringing inflation lower.

A tight labour market is another issue that is stoking inflation with wages now a significant contributor to inflation, while post-Covid, the workforce has fallen by a little over 1%.

External shocks are playing a significant part in the volatility of the economy. The rise in energy prices and the conflict in Ukraine have created headwinds that could still blow it off course.

Inflation is still rising despite four consecutive interest rate hikes, yet Bailey believes that the Bank hasn’t been timid in tightening monetary policy, with hikes being delivered almost apologetically.

When the decision was first taken that the time had arrived to tighten monetary policy, there was a large degree of concern about the ability of the nascent recovery from Coronavirus to continue if the Bank were to be too aggressive.

The contrast between the actions of the Federal Reserve and the Bank of England has led to a depreciation of the pound, but that is a minor contributor to the whole inflation scenario.

While a recession is a real danger, Bailey refuses to accept that the Bank of England’s actions are driving the economy towards a significant contraction.

Yesterday, Sterling continued its recent rally versus the dollar. This is still to be considered as a correction, since there are no Sterling bulls believing that the currency is likely to recover substantially from its recent fall.

The pound rose to a high of 1.2601 and closed at 1.2588.

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Biden sees the inflation fight as a long haul

President Biden accepted, in a speech yesterday, that the fight being waged against inflation will be a long haul. He expressed his confidence that the FOMC is considering its actions carefully and a recession is far from being inevitable.

Biden, speaking in Tokyo, believes that the U.S. economy is going through a historic transition that reduces its reliance on fossil fuels. It seems that every president believes that his Presidency brings historic change!

There continue to be major initiatives being undertaken in the use of alternative energy sources, with several states legislating to encourage businesses to use solar and wind power.

Biden recently authorized the release of stock from the strategic oil reserve, but so far, the level has been insufficient to feed increased demand. This has been fuelled primarily by concerns over the conflict in Ukraine, although there is no real evidence of stockpiling.

There is no doubt that supply chains continue to be disrupted, often by matters outside the President’s hands, and fuel for the transport sector has been one factor.

There is a large amount of grain in storage in Ukraine that the country has been unable to export, and that has created food shortages.

Biden went on to call upon OPEC to raise production and also said he is considering lowering tariffs placed on imports from China that were used by his predecessor as a stick to beat one of the country’s most important suppliers.

Jerome Powell was finally sworn in for his second term as Chairman of the Federal Reserve. Having been plucked from a career in law by President Trump, Powell has brought a fresh perspective to the role and has certainly ruffled the feathers of several Wall Street institutions. He has shown that the economy is run for the entire population, not simply highly paid bankers.

Powell will be making a speech later today, in which he is expected to provide some advance guidance on the Fed’s path following the rate rise that will be made at the next FOMC meeting. Despite inflation appearing to moderate, at least in its rate of increase, there is a possibility that the size of the monthly reduction in the Central bank’s balance sheet will be increased, even before it has started.

The dollar index continues to correct and, just as there are no Sterling or euro bulls, neither are there any dollar bears who have taken anything other than short term short positions to take advantage of the correction.

Yesterday, the dollar index fell to a low of 102.04 and closed at 102.07. Having broken below support around 102.50, the correction will likely be a little deeper than had previously been predicted.

Rates likely to be in positive territory by Q3

Christine Lagarde has barely reacted to the recent data, which showed that there is a possibility that the average rate of inflation in the Eurozone is moderating.

Instead, she now appears to be fully onside with a series of rate hikes starting in July, that will bring interest rates back into positive territory.

Over the course of the year so far, the ECB has been moving towards a policy normalization.

The first action was to reduce then withdraw asset purchases under the Pandemic Emergency purchase programme. This is now complete, and the Bank can move on to a genuine attempt to bring inflation back to its target level. With the emergency support now at an end, the level of purchases under the regular Asset Purchase Plan have also been reduced with a view to ending this support by the end of next month.

There have been severe headwinds that have slowed the process of normalization, but there is no doubt that the reluctance of the ECB President to engage in the withdrawal of support has driven inflation higher.

There is still a disagreement between the more dovish nations of the Eurozone, who see increased public spending accompanied by budget deficits as the best way to increase activity. On the other hand, the more bearish countries do not believe in paying people not to work and believe that rising inflation is the biggest threat to the region’s stability.

Along with the realignment of investor expectations has come a slow but growing confidence any slowdown in the economy or recession will be shallow and only last into the early months of 2023.

Later today, data will be released that will show that activity in both Germany, the largest economy in the Eurozone, and in the whole Union has begun to turn the corner.

Recent data showed that the pace of the rise in inflation is slowing and while a return to the period between 2012 and 2020, when inflation was too low, is unlikely,

Yesterday, the euro rose to a high of 1.0697, closing at 1.0690. The next staging post for the current correction is 1.0850 although whether there is sufficient impetus to test that level is open to doubt.