24 May 2024: A June cut remains in the balance

The publication of the latest inflation data may have been swamped by the announcement of the General Election, but the reaction of a fall in price increases from 3.2% to 2.3% is a significant milestone on the path to lower interest rates.

Although the government cannot take more than minimal credit for the fall, there is little doubt that it will form a significant cornerstone in its efforts to be re-elected.

The headline rate of inflation is now at its lowest level for three years, driven mainly by a substantial fall in energy costs.

Much as the Opposition will have blamed Sunak and Hunt for inflation rising to close to 11% a year ago, they will try to play down the fact that it is now at a quarter of that level, far exceeding the Prime Minister’s pledge that it would be halved by the end of last year.

The economy exited the recession it dipped into at the end of 2023 spectacularly, with GDP growth in the first quarter of this year of 0.6%.

Although the IMF has raised its forecast for full-year 2024 GDP to 0.7% from 0.5% and commented that the economy is heading for a soft landing, quantified as a change from a level of growth that promotes a rise in inflation, to moderate growth with inflation at or close to the Central Bank’s target, it was critical of the cut in national insurance that took place during the Autumn and Spring Budgets.

It is fearful that an economic black hole of approximately thirty billion pounds with a cut in public spending, or an increase in indirect taxation, is needed to repair it.

It is natural for a government to do as much as possible to encourage voters, while also using mild scaremongering tactics to warn of the dangers of voting for a Labour Party which has a record of high taxes and excessive borrowing.

If he is elected, Keir Starmer will have a “honeymoon period,” during which he will hope that geopolitical events do not undue his vision for the country.

He and senior members of his team will have the “luxury” of being able to blame the government for the “mess” the country finds itself in. However, having been critical of the progress made during this Parliament, he will be responsible for cutting NHS waiting lists, the issues with the criminal justice system and upgrading the country’s transport infrastructure while balancing foreign policy and the relationship with the European Union.

The election will indeed be fought with the economy front and centre, but Labour will need to create a manifesto that is appealing and realistic if it hopes to govern for more than one Parliament.

The Pound fell in reaction to the uncertainty created by the upcoming election, despite the market’s view that a rate cut in June may be far from a done deal. Andrew Bailey will be acutely aware of the dangers of cutting rates unless conditions are overwhelmingly in favour of doing so since he will want to avoid accusations of political bias.

Sterling fell to a low of 1.2685 and closed at 1.2688.

Employment data is fast overtaking inflation as the most significant driver of the financial markets. The publication of weekly jobless claims is receiving a level of attention that it never has before warranted.

Wages, which form part of the overall employment picture, are still rising faster than headline inflation. Wages are compared to inflation but are not considered part of the “basket.”

As inflation continues to fall, there is a lag as wage settlements tend to take place based on historical data since workers negotiate wage increases based on their actual expenditures.

Therefore, as demand shrinks due in part to interest rates being raised, jobs become less plentiful, and workers are willing to accept lower settlements.

Eventually, it is hoped that there is some form of equilibrium reached. This is what constitutes a soft landing, where inflation reaches the Fed’s target of 2% while GDP continues to grow at something close to its long-term trend.

Jamie Dimon, the CEO of J.P. Morgan has been prominent for his pronouncements on the economy over the past year. He has been voicing his concerns about a coming recession unless the Fed cuts rates, even though the economy appears to have coped well with a Fed funds target of 5.25%-5.50%.

Yesterday, Dimon voiced his concern that the FOMC could conceivably raise interest rates again since deflation appears to have stalled at a level significantly higher than its target.

With interest rates already at a two-decade high, the effect on the economy would be significant. The dollar is already well above its long-term average and another high could see the dollar index reach 1.15 or even higher, particularly since other G7 are imminently going to cut rates.

Even though several members of the FOMC have hinted at rates rising, their comments have been taken more within the context of a particular set of circumstances which have a less than ten per cent chance of happening.

Earlier this month, Reuters updated a running survey of economists who were asked when they expect to see the Fed begin to cut rates. Almost two-thirds of the economists surveyed believe the first reduction will come in September, to a 5.00%-5.25% range. This was seen as a more hawkish view a month earlier as a quarter of those surveyed believed that a cut would happen in July. There was no indication that the Fed may hike rates.

It will take a significant fall in the headline number of new jobs created for the Fed to return to a more dovish outlook, and this would need to take place over at least three months’ reports.

The dollar index appears to have bottomed out as fears of a slowing of the economy have petered out. Yesterday it rallied to 105.11 and closed at 105.03.

The Eurozone is almost ready to join the rest of the G7.

Its economy is beginning to perform closer to its expected level, while the fall in inflation will encourage a cut in interest rates from their historical highs. This, in turn, should encourage business, investor, and consumer confidence to rise,

However, there is still a “hawkish undertone” emanating from the ECB which could be construed as a reluctance to ease monetary policy until inflation is not just beaten but mortally wounded.

This is an unrealistic premise, since not only is inflation a fact of life, but a moderate rise in prices is considered both healthy and vital for an economy to thrive.

The European Central Bank is likely to cut its key rates by twenty-five basis points when the governing council meets at the beginning of June, ECB Vice President Luis de Guindos has indicated in an interview published yesterday.

Short of announcing an immediate cut, this is the most certainty that has come to Frankfurt since speculation about a cut in rates began almost six months ago.

De Guindos declined to predict ECB moves down the line. He pointed to an elevated level of uncertainty and said nothing had yet been decided. The governing council would await developments in the economic data.

Accompanying the predicted rate cut at its June meeting, the ECB will public its predictions for growth and inflation, this may provide the market with some basis to consider further cuts.

However, it will be a tough task for the doves on the committee to gain the upper hand given the “heavy hitters” who are cautioning against expectations of a cycle of cuts.

Isabel Schnabel, the ECB’s arch-hawk, will make a speech later today in which she is expected to reiterate her call for caution from the market about the future path of interest rates.

The Bank of Spain Governor will also make a speech, but he is only expected to endorse the upcoming rate cut. Pablo Hernandez de Cos will confirm that the Q1 wage data has eased sufficiently for a cut to take place, although there has been worrying news about the apse of wage growth in Germany, the Eurozone’s largest economy.

German wages rose at the fastest pace for almost a decade, pointing to a pick-up in the wider Eurozone and casting doubt over how aggressively the European Central Bank will cut interest rates this year.

Collectively agreed wages in Germany rose 6.2 per cent in the first three months of the year, accelerating from 3.6 per cent in the previous quarter.

This puts the possibility of a further cut before early Autumn into some doubt.

The euro continued to lose ground yesterday despite good output data from the service sector.

It fell to a low of 1.0804 and closed at 1.0815.

Have a great day!