27 January 2023: MPC, two hikes away from the peak

Following Andrew Bailey’s assertion that inflation is about to begin to fall more rapidly, the market has begun to speculate on how many more interest rate hikes the MPC will deliver before they pause.

The UK has a higher average level of interest rates historically than several of its competitors, so the level at which rates become restrictive is likely to be higher and certainly higher than it is at present despite over a years’ worth of interest rates.

Since rates have been at historic lows in order to combat various crises that have affected not only the UK but the global economy as well, borrowers have got used to a new paradigm that didn’t exist in the last three decades of the last century.

The gradual increase of interest rates over the past fourteen months has allowed borrowers to avoid the level of pain usually associated with tighter monetary policy. Given the circumstances that have surrounded the country politically, socially and financially, rising interest rates have not provided the shock that would usually be expected to the economy.

Brexit has been delivered, but following the jingoistic leave campaign orchestrated by Boris Johnson and Nigel Farage, there is the real probability that a majority of voters feel that it was the wrong decision.

There have been very few benefits to business have been seen, while the man in the street has been left bemused about the entire process, which seems to be as much about where the border between the mainland and Northern Ireland should be placed.

As Bailey’s comments have provided a cautious sense of optimism that the downturn won’t be as bad as had been expected, the property market is unlikely to see the rout that had been expected.

Although the rise in house prices has levelled off, expectations that prices will actually fall have been tempered.

The property market is one of the key barometers across the entire country of the state of the economy. It could almost be argued that lenders had gone too far in creating new products with low fixed term rates and were in danger of creating a bubble.

Inadvertently, the Bank of England may have engineered a soft landing for this sector of the market and allowed both buyers and sellers to return to a sense of reality.

Next week, not only is the MPC meeting when Andrew Bailey will deliver his quarterly economic report, but there will be data released that will confirm the slowdown in the housing market, as well as numbers for services output.

Sterling is enjoying a relatively unpressured period as market confidence returns in the Government’s running of the economy.

The pound rose to a high of 1.2430 as traders tentatively consider a test of the 1.25 level. It fell back to close at 1.2414. The outcomes of monetary policy meetings on both sides of the Atlantic will determine its short term direction.

The programme of hikes in short term interest rates appears to have been having the desired effect on the economy. Data for GDP growth in the U.S. in the fourth quarter was released, and it showed that the economy grew by 2.9% in the period between October and December.

This was marginally better than had been expected by the market, which had predicted growth of 2.6%. In an environment where interest rates were at close to zero a year ago and are now approaching 5%, it can be said with a reasonable amount of confidence, that the likelihood of a soft landing which was treated with contempt by Wall Street, is now closer than ever to coming to fruition.

Next week’s FOMC meeting is certain to vote for a further interest rate hike, but the smart money is betting on that increase to be twenty-five basis points.

Gone are the days of extremely hawkish comments from the committee’s members, and this should allow Jerome Powell to continue to gradually change the emphasis of his speech to a more dovish term.

It is doubtful that Powell will ever be considered an inflation dove, given his chastening experience in allowing inflation to rise virtually unchecked in 2021. However, it is increasingly probable that he will be able to deliver an economy that will not be the major talking point at the forthcoming Presidential Election.

With less than two years to go before voting takes place, President Biden will likely be more encouraged to stand again. His handling of the economy, having a hands-off approach and allowing his Cabinet to design and implement policy, is in stark contrast to the performance of his predecessor who was little more than a control freak.

The January employment report will be the highlight of a busy week of data releases, speech and rate decisions next week. Early estimates are for the number of new jobs created to fall to around 50K, which although a significant fall also backs the Current Fed action.

Jerome Powell will no doubt have access to the data prior to the FOMC meeting, and observers will be combing through his words for any indication that the data will be out of line with expectations.

The dollar index was cheered by the GDP data, as it will allow the FOMC to continue to hike rates. It rose to a high of 102.18 and closed at 101.8, right on the line of support.

Inflation continues to be a dirty word within the European Union. Rising prices are the main topic of conversation across the entire Union. To some nations like Italy, it is a fact of life and historically, prior to Italian accession to the monetary union, monetary policy was developed around inflation but not necessarily to contain it.

A similar story is true of the Baltic States where rising prices are also a fact of life but for different reasons. Supply and demand is the most serious driver of inflation, as scarcity of basic foodstuffs, particularly in the winter months, leads to shortages. In Latvia, Lithuania and Estonia, they currently have comfortably the highest rate of inflation in the Eurozone.

The combined population of those three states is around six million, while France, Germany and Italy have a combined population in excess of two hundred million.. When inflation data is calculated, no account is taken of population size, which obviously skews the numbers.

Germany has historically been extremely hawkish about inflation. It is probably about time they abandoned the fearful recollections of the post-war period, when hyperinflation was driven by scarcity of just about everything.

While this experience drove the economic miracle which turned its economy into one of the most efficient and successful in the world, there remains a nagging doubt that the entire country could collapse if inflation is allowed to take hold.

Germany has had to loosen its grip given its membership of the European Union but, joined by other, equally conservative nations, it maintains a hawkish view on prices rises, although it is seemingly unable to differentiate between the sources of inflation. That means that shocks caused, for example, by the current gas crisis are treated similarly to rising prices due to rising demand.

Overall, there is a total lack of unity and cohesion over monetary policy, which creates a level of interest rates that are wholly unsuitable for the majority of Eurozone members.

Next week, the Governing Council of the ECB will meet to agree the next hike in short term interest rates. It is likely that a further hike of fifty basis points will be decided upon. That will cause another round of disagreement from several nations, particularly Italy, which sees tighter monetary policy as the major cause of its economic woes.

The Euro is still garnering a degree of support outside of changes in monetary policy, due in no small part to growing confidence that the region can avoid a damaging recession this year.

However, the single currency fell back a little as it ran out of momentum to test resistance at 1.0920. It reached a low of 1.0850 and closed at 1.0892.

On balance, the euro is likely to be supported next week by the outcome of interest meetings in New York and Frankfurt. While the Fed may see an opportunity to ease market expectations over further rate increases, the ECB remains committed to tighter monetary policy, which should favour the common currency.

Have a great day!