31 May 2022: UK economy stalling rapidly

Bank of England in impossible position

It is considered likely that the Government will need to provide a second round of support, as the cost-of-living crisis is expected to continue well into 2023.

A survey conducted by Citibank has shown that the expectation is that inflation will remain above 6% for at least another year. With a rise in the energy cap confirmed for October, they could easily be another in early 2023 taking the average family’s bill above £3,500.

The end of the low interest rate, low inflation era is well and truly over. Savers will face the dilemma of making sure that their investments are now able to keep up with inflation.

Although interest rates will rise and stay at levels not seen for a considerable time, they will remain below the level of inflation.

Overall, the housing market will also suffer with capital gains hard to come by as mortgage rates rise, encouraging homeowners to stay put and consider other options.

It appears likely that Sterling, having fallen by close to 7% versus the dollar, will remain weak for at least the rest of this year as the economy struggles. A recession remains a better than even chance, while stagflation may have already begun.

A weakening economy with high inflation has always been economists’ nightmare scenario, although there is no common agreement on what constitutes stagnation. Most of the G7 is experiencing rising inflation, while most are now weathering the storm of a faltering economy.

In the developed world, growth levels are continuing to fall as several face additional pressures created by the knock-on effect of the Pandemic. While the cyclical nature of the global economy means that growth will rebound as it adjusts to a new paradigm, the concern is that inflation will be far slower to retreat.

Central Banks are going to take interest rates above neutral levels in order to battle inflation, but at some point, the pressure on output, partly brought about by wage demands from workers unused to facing higher prices for basic foodstuffs will begin to tell.

This is going to be a continuing issue for the UK services output, the mainstay of the economy slips into contraction.

The pound is expected to return to lower levels and eventually test the 1.20 level as the dollar begins to rally again. Yesterday, it struggled to make progress, falling to a low of 1.2610, closing at 1.2616.

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2.5% plus may be needed for some time

Member of the board of the Federal Reserve, Christopher Waller, spoke yesterday of the need to raise interest rates well above the neutral level if the Central Bank is to get a grip on rising inflation. As in the UK Waller fears that higher inflation than has been seen in decades will become ingrained into the U.S. economy.

He favours raising interest rates in increments of fifty basis points at every meeting for the rest of 2022.

Inflation will be a factor in driving growth lower, but the alternative of seeing wage demands continue to grow, creating a vicious circle, is far more damaging.

Demand continues to outstrip supply. Higher interest rates will cool the demand side of the economy since there is no way to increase supply in the current environment.

There is no official figure considered for what the neutral rate is although most consider it to be around 2.5%. With the target for the Fed Funds rate now at 0.75% – 1%, three more hikes will bring it to neutral, although the effect of the reduction in the Fed’s Balance Sheet will also have a part to play.

The reduction commences next month, with the Bank selling off $95 billion of assets every month. That will be made up of $60 billion of Government bonds and $35 billion in mortgage-backed securities.

The question being asked now, although Jerome Powell believes that current Fed policy is sufficient to deal with current inflation, is if fifty basis points is effective, wouldn’t seventy-five be even more so?

Waller, displaying an attitude that is far more hawkish than his colleagues, believes that taking rates above neutral should be the bank’s goal.

Were this to be adopted as Fed policy, it would reignite the fire that sent the dollar index well above 105 recently.

Yesterday, the dollar was fairly quiet with the holiday in the U.S. and the holiday shortened week in the UK.

It traded down to 101., but depending on this week’s NFP data could break below the 101.20 support and test 100.80.

Continued rising inflation to set rates on a higher trajectory

Inflation data for Germany that was released yesterday showed that prices are rising at their fastest level since 1973.

Headline inflation is now rising at 8.7% with core inflation at 7.9%. With the data for the entire Eurozone due for release later this morning, it is likely that prices are rising at close to 8%.

Having already set alarm bells ringing at the Bundesbank, the ECB is facing the prospect of being pressured into not just one hike of fifty basis points, but quite probably a series of similar hikes.

The data from Germany was significantly higher than the market expected, and there is no reason to believe that it will not continue to rise.

The Eurozone is facing the additional pressure created by the conflict in Ukraine.

The European Commission continued to discuss the sixth round of sanctions on Russia, which include agreement over the banning of imports of energy.

The constitution of the EU is committed to unanimous agreement over such policy decisions and Hungary had been frustrating the talks over sanctions due to its desire to continue to import oil from Russia, since the alternative meant the collapse of its economy.

Hungarian Prime Minister Viktor Orban, who is seen as one of the more radical leaders, commented that things are not looking good. Orban is looking for commitments from Brussels in case Russia halts shipments via pipeline in order to put pressure on Hungary to accept the reasons for the invasion of Ukraine.

The final issue of data for consumer confidence was released yesterday. This was unchanged from the preliminary release which saw confidence unchanged at -21.1 down slightly from April’s figure of -22.

Despite confident predictions from the ECB, it is consumers who hold most weight in the prospects for the economy. If they are not spending in shops, online or utilising services, the economy cannot grow.

Yesterday, the euro tested its recent highs reaching 1.0787 and closing at 1.0778.

This rally is a function of a weaker dollar since the euro is now in an overbought position which may see a correction this week.