3 July 2023: Bank of England risking “over-tightening”

Silvana Tenreyro has been an independent member of the Bank of England’s Monetary Policy Committee since August 2017. Over that time, she has “grown into” her role as its most dovish member.

In her final speech as a member of the committee, she spoke of her concern that if the Central Bank continues to hike rates, it will drive inflation to below the Government’s target of 2%.

She believes that the economy has suffered an external shock as energy prices climbed over the past eighteen months, and while it was correct to hike rates through 2022, the hikes that have taken place over the past few months run the risk of being “counterproductive”.

This is the type of radical thinking that looks beyond the “norm,” that several MPs believe should be encouraged by having fewer Bank of England employees on the MPC and more independents.

Members of Parliament believe that the current makeup of the committee runs the risk of adopting “groupthink,” in which they vote as a bloc, thus negating the role of the independent members.

The opposite argument is that if there were more academics on the committee, their discussions could easily descend into considering economic theories rather than dealing with the committee’s basic function and striving to reach targets that the Treasury has set.

Tenreyro leaves her role this week and will be replaced by Megan Greene. Greene comes from a consultancy firm in the City of London, and so far, journalists are intrigued by what she will bring to the discussion on monetary policy.

She joins at a most challenging time since interest rates are on the cusp of becoming restrictive on demand which means that the effect of any further hikes will be magnified.

Over the weekend, several newspapers carried a story that many investors believe that inflation is becoming ingrained in the economy as a wage/price spiral worsens.

With interest rates at their highest level for sixteen years, it is becoming less and less attractive for investors to take the risk of investing in businesses, particularly those susceptible to rate increases.

Later today, data for output in the manufacturing sector last month will be released. It is likely to show that output remained in contraction but was stable.

The “unbalanced nature of the economy means that manufacturing now only makes up around 2% of output. The data for the far more significant services sector is due for release on Wednesday.

Over the rest of the week, the only data due for release that could move the market is house prices, it is expected that after recent volatility in mortgage rates, that house prices should have stabilized.

While house prices are not part of headline inflation. They do affect core inflation, and the MPC will be keen to see any rise kept to a minimum.

Last week, Sterling lost a little ground overall versus the dollar. It fell to a low of 1.2591 by rallying to close marginally lower at 1.2699.

Although Jerome Powell has provided very clear guidance to the market that the FOMC will return to its cycle of rate hikes at its meeting later this month, there is still a significant “school of thought” that having skipped a hike last month, and not having suffered any serious consequences, members of the committee may be encouraged to extend the pause further.

Jerome Powell’s hawkish rhetoric makes further hikes in the second half of the year all but certain, but there is a feeling that inflation may need a quarter to “catch up” with what has happened so far this year.

The minutes of the most recent FOMC meeting will be published on Wednesday, and they will be studied more closely than they have for some time to discover the attitude of members towards a longer pause,

The picture for growth in the country has become regionalized, so while there may be some regional Fed Presidents who are seeing at or above trend growth that requires “damping down,” others will be concerned that their regions are still on the brink of a recession.

Bank of America, one of the largest commercial banks in the country, spoke in a note to shareholders last week of its view that inflation may “fall like a stone,” without provoking a recession.

Their analysts believe that the current shape of the treasury yield curve, a well-used predictor of recession, indicates a hard landing for inflation, but not necessarily the economy.

They feel that the Fed will continue to be biased towards tighter monetary policy but will go forward far more cautiously than they had before June’s pause.

Jerome Powell, speaking last week, said that he believes that two or three more hikes may be necessary to defeat inflation, but that that doesn’t necessarily mean that they must resume this month.

As well as the Fed minutes, the all-important June employment report will be published on Friday. The headline new jobs data will go a long way towards making the market’s mind up about the FOMC decision later this month.

The Dollar Index steadied itself last week following a substantial fall when the Fed paused a couple of weeks ago. It rose to a high of 103.54 but fell back to close virtually unchanged at 102.92. This index is likely to gain from the continued divergence between the U.S. economy and those of its G7 partners.

Christine Lagarde is a politician primarily. However, since she was something of a surprise choice to be President of the ECB following a stint as Managing Director of the International Monetary Fund, she seems to have “got a taste” for the financial world.

There is little doubt that over the first half of this year, she has allowed her own views to come to the fore rather than trying to act as an “honest broker” when chairing the Governing Council of the Central Bank.

She has been as hawkish as the most determined of her colleagues and clearly wants to see the job through to the end.

When she was appointed, it was expected that after her term in office she would return to her political life.

Therefore, the news that she had turned down the French President’s offer to become the Prime Minister of France received a mixed reaction.

Her refusal means that the incumbent, Elisabeth Borne, is expected to remain in situ despite being the architect of pension reform, which caused significant unrest in the country.

Lagarde has become a central figure in the ECB’s quest to defeat inflation in the region, but as in the UK, fears are growing that it is becoming ingrained in the economy.

Being a “twenty-headed” monster, it is close to impossible to bring every member of the EU into line to defeat price rises. There is a wage/price spiral beginning, but Lagarde spoke last week of her belief that continuing stubborn inflation is due to a greater extent to the profits being made by Eurozone companies.

Several of her more dovish colleagues still believe that continued high inflation, which is now creating a “second wave” as it works its way through the entire economy, is due to the energy shock of the past eighteen months and the effect of the war in Ukraine.

Lagarde appears to only want to acknowledge matters she can deal with and clearly feels the war in Ukraine, despite still raging on the Union’s doorstep, is beyond her purview.

This week, PMI data for individual EU members as well as collectively, will be published. They are likely to confirm the continued slide into recession.

Last week, the Euro was in reactive mode as the market pondered the path for U.S. interest rates. The ECB has no issue in that regard. It is set on a path to raise interest rates until inflation is defeated, no matter the economic consequences.

The common currency traded in a narrow range between 1,0976 and 1.0835, closing at 1.0910. It remains within “striking distance of the 1,10 level, but there is significant resistance to overcome before a breach of that level becomes clear.

Have a great day!