BoE decision on a knife-edge

The Monetary Policy Committee will conclude its latest meeting at lunchtime today. While the outcome of the meeting remains too close to call, continued expansion in the economy means that the odds slightly favour a rise in interest rates.

The size of any hike is also in question. It may be ten basis points, or it could be twenty-five. Whatever happens, the outcome of the meeting is sure to have a significant effect on the outlook for the economy in the short to medium term.

Services PMI rose in October from 55.4 to 59.1 beating the flash estimate by a considerable margin. Business costs are rising at what is becoming an alarming rate, and these are being passed on to consumers, resulting in a continued rose in inflation.

The surge in operating costs reported by services companies was the highest since 1996.

Although the vote will be close, a hike in rates now would send a signal to the market that the recent comments regarding inflation being transitory have now been superseded by events.

Despite rises in pay and conditions, the IHS Markit Survey noted that the labour market remains tight. Reports of unfilled vacancies are high. This is clearly an outcome of Brexit which is unlikely to subside for some time as the rebalancing following the UK’s departure from the EU continues

Fuel prices are continuing to rise, with prices at garage forecourts being revised upwards almost daily. The economy appears to have regained the momentum that was in danger of being lost, as the ability of the major suppliers to get petrol and diesel to their petrol stations threatened briefly to derail the recovery.

The Bank of England will be keen to show that it is serious about containing inflation but will be wary of choking off the recovery, which is still fragile.

Andrew Bailey reported in October that the bank is likely to act if medium term expectations for inflation rose above 2% and while there have been comets from MPC members that they still consider bottlenecks in supply chains as the major cause of price rises, they may wish to be seen to be expressing their concern in more than words.

The pound rallied yesterday versus the dollar following the action taken by the Federal Reserve. It rose to a high of 1.3692, closing at 1.3686.

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90% chance that Fed will hike in H1

The Federal Reserve, as was expected by the market, will begin the taper of its additional support for the economy this month. The Central bank had been buying $120 billion in securities per month, split between $80 billion of Government bonds and $40 billion in mortgage-backed securities.

That will be reduced by a total of $15 billion in the first instance. This will be split $10 billion in Government Bonds and $5 billion in Mortgage-Backed Securities.

In his press conference following the meeting, Fed. Chairman Jerome Powell emphasized that this was a natural progression as the economy is recovering, despite having a considerable distance still to travel.

The Fed didn’t commit to the level of purchases past December, and this provides it with a degree of flexibility to act in accordance with market conditions. It is entirely prudent for the Bank to act in a manner that is reactive to the situation at the time.

While FOMC members will be providing their regular regional updates together with their estimates for growth and inflation, decisions will be made based upon actual conditions.

The market’s attention will now turn to tomorrow’s payroll numbers. The private sector data that was released yesterday showed a moderate rise from the September data, but it remains strong.

Today’s release of weekly jobless claims is expected to continue its trend lower. The four-week average is now below 300k and is likely to fall further.

At Jackson Hole back in August, Powell emphasized that the taper of asset purchases and a hike in interest rates face two entirely different tests.

With the taper having begun, the market will start to look towards tighter monetary policy. Inflation remains an issue but is expected to begin to subside in the New Year.

Should that not happen, pressure will begin to rise for a rate hike. It is not expected that the Fed will hike until the taper is complete, so having only committed to this level of reduction until next month, an acceleration could easily be seen in January.

The dollar index lost ground following the announcement. It fell to a low of 93.81, closing at 93.86.

Eurozone unemployment is beginning to fall

With the Fed having acted and the Bank of England leaning towards a rate hike at today’s meeting, the ECB continues to plough its own farrow.

The ECB President spoke yesterday of the unlikelihood that the ECB would be hiking rates next year even as it renews its latest support plans, which expire in March.

It seems that the complete shift in the emphasis of monetary policy that was begun with the change in inflation policy in the late summer is coming to completion.

Lagarde has succeeded in changing the mindset of the Governing Council, which now sees growth as the way of healing the structural issues that remain within the Eurozone.

This is something that hadn’t been considered, given the way the ECB had been modelled on the inflation cruising policies of the Bundesbank. While Jens Weidmann wasn’t the architect of such a policy, it seems ingrained in the German psyche, he was a willing servant.

Now that Weidmann has decided to retire at the end of the year, there will be a void to fill once the German Government is able to form a coalition following the elections that were held in the Summer.

Lagarde spoke yesterday of the three conditions that need to be met in order for the Central bank to consider hiking rates. These have been made clear in the Bank’s advance guidance.

Lagarde said that the use of PEPP will continue as a method of ensuring that liquidity is available to oil the wheels of the economy and ensure that interest rates do not tighten unnecessarily.

While growth is favoured over inflation, rising prices remain a concern but also remain transitory.

Francois Villeroy de Galhau, President of the Banque de France, a member of the ECB Governing Council and one of Lagarde’s closest supporters, agreed that interest rates do not need to rise yet. He believes that inflation will fall back within an acceptable range early in the New Year.

The euro rallied on the back of a weaker dollar yesterday. It reached a high of 1.1616, closing at 1.1611, although it still seems only a matter of time before diverging monetary policies see it break below 1.15.