30 August 2024: The threat of persistent inflation has fallen

Two members of the Bank of England’s Monetary Policy Committee have fundamental differences over the inflation path due to “secondary effects”.

Bank Governor Andrew Bailey said in his speech at the Federal Reserve’s Jackson Hole Symposium that while it is too early to declare victory over inflation, the risks of persistent inflation appear to be fading.

Meanwhile, Independent MPC member Catherine Mann, who has consistently supported tighter monetary policy, said in London recently that she believes that secondary effects, which are commonly caused by elevated wage claims related to inflation fears, will continue for “many years.”

Mann voted against this month’s cut in interest rates and said in the Financial Times podcast that she put her hawkishness at 7 out of 10, down from 10 out of 10 earlier this year when she voted to raise rates further from their 16-year high of 5.25%.

There is an upward ratchet to both the wage-setting process and the price process, and it may well be structural, having been created during this period of extremely high inflation over the last couple of years, she said.

Mann, who was appointed to the MPC by Jeremy Hunt in 2021 was recently re-appointed to serve a further three years as a rate-setter.

Her views perfectly illustrate the dilemma faced by the Bank, which, on the surface, appears to have a two-tier approach to monetary policy. The danger in appointing so-called intellectuals to serve in what is essentially a bureaucratic role is that they are generally driven by their theories about future developments, paying little attention to factual evidence such as economic data.

This has been true of Christine Lagarde’s appointment to replace Mario Draghi at the ECB. Lagarde has no practical experience in managing monetary policy and has often been criticized for her more diplomatic, less bureaucratic approach, which draws her into always looking for compromise rather than looking for what is the right path.

A contrast has been seen in the U.S. where Jerome Powell is aware of his shortcomings economics-wise and often defers to his more experienced colleagues, while retaining his lawyer’s “pragmatism”.

Given that the vote was 5-4 in favour of a cut at the last MPC meeting, the decision will certainly be on a knife edge again next month.

With the normally hawkish Jonathan Haskel having stood down from the committee, his replacement Professor Alan Taylor’s vote is moot given that even if he follows Haskel’s lead the effect, if everyone else votes as they did previously, is that rates will again be cut.

Bailey Breedon, Lonbardelli (in her first meeting), Ramsden and Dhingra voted for a cut. The fact that inflation rose marginally in July the only “swing vote” may be Lombardelli given that little is known about her attitude to the rise in inflation.

The pound is being driven by the market’s view that overall, the Fed will be more proactive in cutting rates than the Bank of England and will therefore loosen monetary policy more over the rest of the year, which will see the pound retain the gains it has made against the dollar recently.

Yesterday, it lost ground, due mainly to the dollar’s recent correction being somewhat overdone. The pound has support at the psychologically important level of 1.30. It closed at 1.3170 having fallen as low as 1.3145.

Given that Q2 GDP was revised upwards to 3% from 2.8% yesterday, it is odd, but not entirely unexpected, that Jamie Dimon the CEO of J.P. Morgan, the major Wall Street financial institution would choose yesterday as the day on which he predicted that the FOMC may cut interest rates by fifty basis points at its meeting next month.

Dimon has been constant in his warnings that the Federal Reserve has risked a recession by focusing monetary policy on driving inflation down and not being concerned about the other leg of its mandate, which is to promote job growth.

Over the past month, there have been two significant revelations about the employment market, which may have driven Dimon’s comments yesterday.

First, the economy created over 800k fewer jobs in the year to March. Although that number was less than the one million overstatement that was predicted, it still came as a shock to the market.

That was followed by a significant fall in the number of jobs created in July. 114k new jobs were reported in July, down from 178k in June and less than the 175K predicted by the market.

The market’s prediction is of less significance since it has an abysmal “track record” for predicting this particular data release. However, the fall on a month-to-month basis should, in Dimon’s opinion, should set alarm bells ringing at the Fed.

Jerome Powell will consider any action based upon a single month’s data to be a knee-jerk reaction and will want to see the August Employment report, due for publication a week from today, before deciding how he will vote at the September 19th meeting.

The surprise upward revision in GDP that was published yesterday came on the back of significantly stronger consumer activity than had been previously reported. The fact remains that the Fed has never cut rates when the economy is producing such robust growth data, and putting Powell’s comments last week to one side, the Fed’s decisions would still be “up in the air”.

Inflation, as measured by personal consumption expenditures, a wider measure than the “basket” used to measure Consumer Price inflation fell to 2.5% in Q2, down from 2.6% previously reported.

The dollar index reacted positively to the data. It rallied to a high of 101.58 and closed at 101.39.

Inflation data from Germany and Spain was published yesterday and both showed that price increases are now well controlled.

In Germany, price increases fell to 1.9%, down from 2.3% previously while in Spain, inflation was at 2.2% in August, down from 2.8% in July.

This should make a rate cut at the next meeting of the ECB’s Governing Council a “no-brainer”, but making predictions about how the twenty-six-person committee will vote is “akin to herding cats”.

The disinflation trend is expected to play out in the eurozone’s other two biggest economies – France and Italy – when numbers are published on Friday. There’ll also be figures for the bloc itself, where the market sees a retreat to 2.2 per cent and Economists predict a return to the 2 per cent target.

The ECB, particularly its President, Christine Lagarde, is unlikely to make any predictions about the September 12th meeting given that she was criticized for “jumping the gun” following earlier meetings.

With price gains moderating in line with ECB projections, wage pressures easing and economic momentum faltering, officials in Frankfurt have warmed to a September rate cut.

That would be the second reduction after a first step in June began unwinding the spate of hikes enacted to tame record inflation.

Policymakers, though, have also cautioned that there may be setbacks in the months ahead, stressing that their fight isn’t yet won. Underlying price growth is still strong and increases in services costs in particular are still a big concern.

The market would do best to consider the speech made by ECB Chief Economist Philip Lane at Jackson Hole last week.

He noted that while the second half of this year will still witness “plenty of wage increases,” the momentum is expected to taper off significantly.

Lane emphasized that “the catch-up is peaking now,” suggesting that the pace of wage hikes will slow substantially over the next two years. Wage rises have been the major concern of his colleague on the Bank’s Executive Board, Isabel Schnabel, who holds similar theories about “secondary effects” as Catherine Mann.

The Euro’s recent gains have been due to both overly hawkish views of the ECB and the general lack of liquidity seen by the market during the summer.

Both have now abated, leaving the single currency vulnerable to further declines.

Yesterday, it fell to a low of 1.1055 and closed at 1.1077. A test of the 1.10 level is likely as the market considers the relative strength of the economies of the U.S. and Eurozone, as monetary policy is likely to be loosened on both sides of The Atlantic.

Have a great day!