26 August 2022: Targeting inflation may be outmoded

GBP – Modern economy doesn’t react to domestic monetary policy

There is an emerging theory that targeting inflation by tightening domestic monetary policy may be becoming less effective as globalisation creates pressures in economies which cannot be cured by dampening demand.

Across the developed world, Central banks have been tightening monetary policy for most of this year, but there has been no noticeable effect on inflation.

The UK is a case in point.

The Bank of England began to hike interest rates last December, but inflation has continued to rise and is predicted to continue to do so, possibly reaching 18% by the end of this year or the beginning of 2023.

There have been factors at play which have worsened rising inflation, the most obvious of which is the war in Ukraine, which has driven the wholesale price of gas to extraordinarily elevated levels.

While the cost of energy and, to an equal extent, the cost of basic foodstuffs make headlines, there has been an underlying shift in the ability of individual countries to control their own economies using tools which are beginning to look out of date.

Monetary policy is only able to affect demand while in many cases since the beginning of the Pandemic, it is supply that is the issue and this stems primarily from the ability of China to supply finished goods while supply chains struggle to keep up.

Today sees the announcement of the next increase in the energy cap, which will come into effect on October 1st. This is certain to increase calls for the Government to act to provide greater support. Stories of people having to choose between eat or heat no longer appear to be sensationalised and the country is facing a crisis that will rival the Pandemic in its seriousness.

The Conservative Party leadership election cannot come quickly enough with Boris Johnson seemingly unwilling to fulfil his duties despite claiming that it was vital that he stay in office until a new leader is elected. The Government is in a state of paralysis, with the two candidates continuing to produce sound bites, but little more

Liz Truss continues to promise help with energy bills without putting any meat on the bones, while Rishi Sunak criticised the Cabinet response to the Covid-19 crisis which he believes was worsened by placing too much power in the hands of experts.

With the election result soon to be announced, the new Prime Minister will face several serious challenges as the economy falters and both inflation and the cost of living rise almost out of control.

The pound has been stuck in a 1.1875/1.1740 range this week, with traders awaiting today’s speech from Fed Chairman Jerome Powell. It may come too late for any major effect today and heading into a long weekend, volatility will begin to rise next week.

Yesterday, Sterling reached a high of 1.1864, but ran into selling pressure and fell back to close at 1.1832.

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USD – Powell likely to keep hawkish bias

While the U.S. economy is in a technical recession having seen two consecutive quarters of negative growth, the situation is not as bad as it has been painted with both quarters seeing a contraction of less than 1%.

A 0.9% contraction in Q1 was followed by a 0.6% contraction in Q2. it is expected that Q3 will be similar or could possibly see a return to a similar sized level of growth.

Thai has confounded those who believe that the extremely hawkish actions by the Federal Reserve will push an already fragile economy into a full-blown recession.

The two most significant factors that are in play are first that the Fed’s actions have done no more than bring interest rates to a neutral state after almost a decade of accommodative monetary policy.

Evidence of this can be seen in the growth of equity markets. The DJI has risen from 6470 in March 2009, to 34200 this month.

Stories that the Fed is targeting a cooling off for equities are clearly wide of the mark, since even a further seventy-five basis point increase at the next FOMC meeting will only bring rates to a mildly restrictive level which is unlikely to cause widespread panic for fund managers.

Even the major growth stocks like Netflix, Apple and Amazon have confounded those who believe that their long run may be ending. Predictions, for example, that Netflix could begin to lose subscribers as the cost-of-living rose have failed to consider the sea-change there has been in consumer behaviour globally.

The Fed is determined to continue to target inflation but may be prepared to slow the rate at which it tightens monetary policy over the rest of 2022. With just three meetings left this year, a seventy-five-basis point hike at the meeting on September 21, could be followed by a pause or maybe a further one hundred points combined in November and December.

The FOMC is still data driven, so a lot will depend on the outcome of the upcoming employment reports, which will add to core inflation if they still are as strong as they have been for most of this year.

It is unlikely that Powell will deviate too much from recent statements when he speaks at Jackson Hole later today. He is not expected to announce any meaningful change to Fed policy and will reiterate his view that the economy is not in recession despite the recent contractions.

The dollar index is still well-supported but has so far failed to break above its recent highs. Yesterday, it fell back to the bottom of its recent range, reaching a low of 107.98, but bounced back to close at 108.43.

EUR – ECB to justify rate hike as support for currency

The overall path for the euro so far this year has been fairly predictable so far in 2022, although there have been some quite vicious corrections which have caught the market unawares given its overall bearish sentiment.

The war in Ukraine has come close to crushing the Eurozone economy, and still has the potential to do so as Russia punishes the region for the sanction it has enacted.

The serious reduction in supply of gas has the potential to bring energy rationing to Germany and any recession in the region’s strongest economy will see significant fallout for the rest of Europe, whether within the European Union or not.

In the days before the advent of the single currency one of the factors that kept the Deutschmark strong was the fact that Germany used monetary policy to control inflation.

A weak or weakening currency adds to inflation by increasing the cost of imports. However, it does provide support to exports as they come cheaper to overseas buyers.

That is where the Bundesbank and European Central Bank clash. BUBA believes in a strong currency to provide a cushion against rising prices, while the ECB wants to support weaker economies by having a currency which helps promote experts.

Germany has been a benchmark for financial discipline but has relied on quality rather than price to advance its ability to export.

This year’s fall in the value of the euro is estimated to have added around 1.5% to the level of core inflation. This is not insignificant in normal times but given the rising cost of energy and foodstuffs is believed by the Central Bank to be acceptable given the support it provided to exporters. Germany disagrees.

The minutes of the latest ECB meeting flag the fact that more interest rate hikes are to be seriously considered. This is about as strong a commitment as the market can expect from the Bank given the calamitous state of the economy and the possible futility of rate hikes given the other factors driving inflation outside of demand.

The Euro managed a rally yesterday as the dollar faltered but is unable to break back above parity. It rose to a high of 1.0033, but saw major selling interest which drove it back to close at 0.9974