27 April 2022: Hike may lead to Bank sell bonds

Bailey may face some awkward questions

Bank of England Governor Andrew Bailey, when questioned about when the Bank would begin to wind down its support for the economy by divesting itself of Government Bonds that were purchased in order to add liquidity to the market during the Pandemic, answered that he imagined it would start when interest rates reached 1%.

Bailey has developed a habit of answering questions about long-term issues without giving them due consideration, and often pre-empting the opinions of his colleagues on the MPC.

While the opinion of the Governor carries significant weight, the Monetary Policy Committee comprises nine individuals and each vote carries the same weight.

Popular opinion suggests that the mood of the MPC is sufficiently hawkish for them to agree to a further rate hike at next week’s meeting, despite clear evidence of a slowing economy.

If the hike takes place, the rate will reach 1% and questions will be asked about the expected reduction in the size of the bank’s balance sheet.

While inflation continues to rise with expectations that it will reach 10% common, withdrawing liquidity by selling bond holdings would be a sensible move, but as the country begins to experience the first signs of stagflation such a move may be considered dangerous.

The MPC is moving into theoretical territory, where there is no previous experience to draw upon to counter what is happening to the economy.

Analysts and observers have their own opinions on the necessary course of action, but those opinions have been grown in a laboratory, and not tested in reality.

If the hike is agreed at next week’s meeting, there is certain to be a period of second guessing, since the decision will fuel academic debate.

So far this week, the pound has remained under pressure as Q1 data has barely convinced the market that a further hike is justified.

Yesterday, it fell against the dollar for the fourth consecutive session. It reached a low of 1.2571 and closed at 1.2576.

With the Federal Reserve appearing certain to hike, in all probability, by fifty basis points, at its meeting next week, the pressure on the pound is likely to continue, irrespective of its own decision.

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Tapering of policy not happening fast enough for FOMC

Jerome Powell’s keynote speech last week at the IMF meeting has lit a fire under the dollar.

Since Powell virtually confirmed a fifty basis-point hike next week, the dollar index, which up until that had entered a consolidation phase, has begun to climb again.

The dollar has garnered favour from an expected divergence between monetary policy between the U.S. and the rest of the G7.

Having been burned once by rising inflation that clearly caught the Bank on the back foot, Powell appears to be determined that it won’t happen a second time.

When the FOMC was considering the taper of its support for the economy, it certainly should have been more proactive and begun to slow its bond purchases.

That has led it to be two, possibly three meetings behind the curve and its current, more hawkish stance, appears at odds with what is happening on the ground.

Market commentators, with the benefit of hindsight, are expressing concerns that two fifty-point hikes, as are being currently considered, may be too aggressive in the current environment.

As in the UK, there is no manual for the FOMC to refer to in order to make the correct decision.

It is unlikely that the slowdown in the U.S. will lead to stagflation as is being predicted for both the UK and Eurozone, but the FOMC is going to have to be prepared to act in unorthodox ways in order to keep the economy on target.

Treating rising inflation and supporting growth is being considered an either/or situation, but it may be that hiking rates and leaving the balance sheet alone for a month or two may turn out to be the correct decision.

Meanwhile, the appreciation of the dollar is one way to fight inflation, although it will need continued hawkish policies to see it continue to rise.

Yesterday, the index rose to a high of 102.36, closing at 102.34. With next week’s monetary policy decision almost a foregone conclusion, the proximity of the April Employment Report could be significant if the FOMC gets a sneak preview of the data.

Lagarde sees U.S. inflation as a consequence of jobs

ECB President Christine Lagarde appeared on U.S. television at the weekend and was keen to say that the rise in inflation in the country differs to what is being experienced in the Eurozone.

She believes that rising inflation in the Eurozone has its roots in the considerable increase in the price of energy, in particular the wholesale price of gas, and is being exacerbated by the conflict in Ukraine. She believes that 50% of the current level of inflation has been caused by the conflict.

Furthermore, she doesn’t believe that the ECB has necessarily fallen behind the curve since the Eurozone is encountering a different beast compared to the U.S. where inflation is firmly rooted in the labour market.

Lagarde will have improved the mood of several of her colleagues on the Governing Council of the ECB by all by confirming that bond purchases would end in the third quarter.

According to her deputy, that means early July.

It is hard to say whether the current situation in Europe is more fragile than in the U.S. but it is fairly clear that it will take some time for the ECB to catch up in terms of monetary policy.

Lagarde’s preference for supporting ailing economies has riled the more hawkish nations of the Eurozone, so her support for ending that support will have been welcomed.

The Eurozone differs from other G7 nations when comparing the concerns over output or activity versus inflation. Where the balance of risk is fairly even elsewhere, in Europe it is undoubtedly skewed towards rising prices given the continued shortages created by the conflict and the imposition of sanctions.

However, the ability of the ECB to effectively fight inflation is hampered by the huge variation in rates across the region.

The euro continues to suffer from the perceived divergence in monetary policy outlook. Yesterday, it fell to a low of 1.0635 and closed at 1.0637.