28 April 2023: Interest rates starting to bite

The Bank of England has been raising short-term interest rates for close to eighteen months in an effort to slow demand and by doing that lower inflation.

It is only now that the base rate has reached a level that is restrictive on economic activity having been accommodative for many years. It is impossible to know without doubt when interest rates become restrictive, since it is as much about attitude as any economic data.

The Bank’s intention when it began its current programme of hikes in December 2021, was for rates to become neutral, where they are neither restrictive nor accommodative, as quickly as possible, without causing undue damage to the economy.

The question now for the MPC is how long do they wish for rates to be restrictive, while risking damage to the economy

It is now moot whether they could have been more aggressive in the size of hikes since there were several imponderables in play that drove their decision-making.

The economy has been struggling for some time with a set of unique issues, Brexit is a prime example and the MPC has been accused of groupthink where the committee’s members are all like-minded, white the three independent members treat the discussion like an intellectual debate.

The release of first quarter profits by Barclays Bank showed that it made its largest first quarter profit since 2011. It is typical that in a period of economic uncertainty that banks struggle for two reasons.

The first is that their customers are uncomfortable investing in their business since they are unsure when they will see a return on funding that will cost more, and second banks face an increase in bad or doubtful loans which prudence dictates they have to provide for which eats into profits.

Barclays’ CEO, while welcoming the figures, cautioned that the country still has a long way to go before business confidence is restored.

CS Venkatatrishnan believes that the outlook, not just in the UK or U.S., but in the whole global economy is a little brighter than it was six-months ago, but they are not yet out of the woods.

Inflation is falling, albeit slowly and growth is flat which is better than the bank had expected, but there is still no guarantee of a soft landing for the economy.

Yesterday, Sterling continued its recent strength versus the dollar, rising to a high of 1.2499 and closing at 1.2497.

Next week, there is no tier one data due for release, so the pound is likely to be driven mainly by outside factors and market confidence over the next MPC meeting.

The release yesterday of the first cut of Q1 GDP was a shock, but little surprise to the group of economists and analysts who have been predicting a slowdown since the second half of last year.

The U.S. economy grew by 1.1% between January and March. The expectation had been for growth of 2% while GDP grew by 2.6% in the final quarter of 2022.

The news will be considered by the FOMC when it meets on May 2nd to consider another rate hike. While the market believed that a further twenty-five basis point increase in short term rates was likely, the lower rate of growth in Q1 may force them to reconsider.

This was not the news that President Biden had hoped for as he began his race to be reelected at the end of next year.

Following the significant fall in consumer confidence that came yesterday, the public are concerned that the country is going to have a difficult Autumn and Winter.

Some hedge fund managers are already predicting that the economy will shrink by 2% in the next quarter and the slowdown will last until year-end.

The rate of growth seen in Q1 is not sustainable under the current conditions. The FOMC may even be forced into a rate cut before the end of the year.

With the Bank of England having taken its time over rate hikes, while the Fed has been far more aggressive, the fall in growth in both nations is an object lesson in how difficult it is to be correct in deciding monetary policy.

It is difficult to imagine a soft landing for the economy now, while a hike at the next FOMC meeting could be considered irresponsible.

The economic data for April, in particular jobs and inflation will now be critical for the path of short-term interest rates.

Yesterday, the dollar barely reacted to the GDP data, possibly considering it to be rearview mirror information while they look forward to next week’s release of employment numbers for April.

The Greenback rose to a high of 101.80 but drifted back to close at 101.48, just four pips higher on the day.

The futile game of predicting the headline non-farm payrolls number will start next week, with early expectations for a significantly lower figure than was seen in March.

The recent rise in the value of the Euro, when just six months ago it was languishing below parity against the dollar, has galvanized ECB President Christine Lagarde to resurrect the idea that the single currency can challenge the Greenback as the the global reserve currency.

Yesterday, Ms. Lagarde warned that the dollar can no longer take for granted its status which she believes provides the U.S. with an unfair advantage in the global economy.

She feels that if the euro were to be the go-to currency for developing nations as well as the unit of exchange for oil and commodities, it would be less prone to weakness.

That is likely to be challenged by both the U.S. and China which may actually agree on an issue for the first time in years.

Lagarde believes that there is a de-dollarization taking place around the world although in the grand scheme this should be considered minor, a bit like a tourist deciding to take euros rather than dollars on holiday as a protest against the political climate in the U.S.

It would only be when he or she wanted to buy something in a remote location that they would find how universal the dollar remains.

The euro still has a long way to travel before it can be considered sufficiently stable to be considered. Although there are twenty countries with twenty Central Banks within the Eurozone and fifty Federal Reserves in the U.S. there is still no comparison over centralization.

The major fiscal policy decisions are still taken by The Federal Reserve although there is some local taxation undertaken regionally.

It remains that only the most committed European would agree with such a proposal, since the EU has more than enough issues to solve before it goes global.

There is no doubt that investor confidence is rising in the region. It is hard to say what came first, the rise in confidence or the rise in the value of the euro.

Each relies on the other, but the feeling remains that the European Union given its comparative weakness at the top, is never far away from a crisis.

The single currency failed to kick on from its break of the 1.10 level versus the dollar yesterday. While it remains supported, it lost ground falling back to a low of 1.0992, but still managing to close above the pivotal level at 1.1028.

Have a great day!