26 July 2023: Three more hikes are expected this year

The Chief Economist at the IMF, in delivering the Funds’ latest review, made a wide-ranging speech yesterday in which he outlined the Fund’s view of the world economy as well as his expectations for growth and inflation.

His most significant predictions were around Europe, where he believes that the UK economy, although still struggling to make any headway, only growing by 0.4% this year, will outperform Germany, which is stuck between stagnation and recession.

Pierre-Olivier Gourinchas told his audience that the UK’s upgrade from a 0.3% contraction in its earlier report was due to stronger-than-expected consumption figures and the confidence that has been derived from the fall in energy prices.

The Windsor Protocol has reduced the level of uncertainty surrounding Brexit, but only Germany will perform worse than the UK among the G7 nations.

The UK’s financial sector has shown “surprising resilience” following the collapse of Credit Suisse and is not showing any signs of a significant issue with bad or doubtful loans.

The Treasury, which pushed back against the previous IMF report, commented that the IMF has complimented the country on its decisive action against inflation, which is now beginning to show real progress.

Elsewhere, a group of prominent economists predicted that the UK would need to raise interest rates three more times over the rest of the year but warned about “front-loading the hikes for fear of driving the economy into recession.

A further warning about recession was made by former Governor of the Bank of England, Mervyn King, who commented that data from the credit markets made a significant rise in inflation inevitable and the Bank should have acted more quickly and decisively to head the issue off. Instead, it dithered about the effect on the growth of rate hikes, and it wasn’t until it was faced with no alternative that it showed the courage necessary.

The Bank of England is expected to return to its pattern of twenty-five basis point hikes when it meets next week, although there remains a possibility that having hiked by fifty basis points at its last meeting, there will be those members who wish to “repeat the dose”.

The three-hike scenario will certainly provide a degree of support for the pound, which has flagged over the past few days, although the comments from the IMF saw it rally against the dollar yesterday.

It climbed to a high of 1.2904 and closed at 1.2902.

Later today, Fed Chairman Jerome Powell will announce the result of the latest vote on interest rates by the FOMC. The overwhelming prediction from the Market is that the Central Bank will return to its cycle of twenty-five basis point hikes that it paused at last month’s meeting.

Although it has had six weeks to digest the pause agreed at the last meeting, the market is still struggling to understand the rationale behind inserting a pause at this point in the cycle. The minutes of that meeting shed little light on the reasoning concentrating far more on future intentions.

Having been at pains to say that the pause in no way signalled that rate hikes are coming to an end, the minutes did say that there would be more space between future hikes.

In its latest report, the IMF said that it believes that the Fed still needs to continue to hike rates due to a concern that headline inflation, which has been falling steadily, will “reignite”, although most of the conditions which caused inflation in the first place no longer exist.

The FOMC will precede the ECB by a day, with both expected to hike by what has become the “standard amount”.

The Fed remains on course to deliver a soft landing for the economy as its two main pillars, inflation and employment, move in tandem towards their target levels. There has been no talk recently regarding the view that the fed funds rate has reached a level at which it will restrict demand, although it is thought that a neutral point where it neither restricts nor promotes demand has been reached.

In fact, it would be a surprise if, even after rising from almost zero per cent over the past fifteen months, rates had not turned neutral.

The decision taken by the Fed later today will drive the currency market for the rest of this quarter. With the ECB and Bank of England both expected to hike by a similar amount to the Fed, despite there being an outside chance of a fifty-point hike in the UK, the dollar has probably found a medium-term base around the 100 level.

Yesterday the index rose to a high of 101.64 but ran out of momentum as traders squared their books in anticipation of the FOMC meeting. It closed the day at 101.26.

The second quarter lending survey conducted by the ECB showed that the tightening of monetary policy that has been going on for more than a year, is influencing company borrowings.

This has further added to the economic weakness that is affecting the entire Eurozone, which is close to stagnation.

Not only has lending suffered but a tightening of credit standards initiated following the collapse of three regional banks in the U.S., as well as the forced sale of Credit Suisse to UBS, which has had a significant dampening effect on lending.

Overall, business investment is falling not just due to loan activity but also the fall in overall investment confidence that was reported recently.

The latest IMF report shows that Germany is expected to have the weakest economy in the G7 over 2023.

It is unlikely that tomorrow’s expected hike of twenty-five basis points by the ECB will materially affect sentiment, but the continued rhetoric about what the Central bank intends to do in September will drive the markets, especially the euro.

The common currency has been hanging on by a thread as its only means of support becomes thinner and thinner. Its recent rally against the dollar, which reached a high of 1.1275, now looks exhaustive, and a fallback well below the 1.10 level is certain if the ECB withdraws the support provided by tighter monetary policy.

With the Head of the Dutch Central Bank appearing to waver in his support for rate hikes after tomorrow, it is only the Austrian and German who are certain to favour further hikes stretching into the Autumn. As the speed of the rate of fall in inflation slows, they will continue to demand further rate hikes, so a lot will depend on the data that is published for both July and August, when there will have been an effective pause by the ECB, as there is no meeting in August.

Yesterday, the Euro saw strong two-sided interest, First, buyers pushed it up to a high of 1.1086 where there was strong selling interest which drove it down to a low of 1.1020 where buyers emerged again, and it rose to close at 1.1052.

Have a great day!