7 February 2023: BoE risking the Hokey Cokey

MPC member Catherine Mann spoke yesterday of her fears that a more dovish view on inflation that she is seeing from her colleagues could see the Bank of England pause the current cycle of interest rate hikes, only to be forced to begin them again as inflation remains at its current high level.

She believes that the tried and tested method of using data to spot turning points in the economy is being ignored due to the pressure being exerted on the Committee by the continuing cost of living crisis.

She feels that rather than seeing the cost of living fall if short-term interest rate increases are paused, or halted altogether, the economy will still see a significant recession in the next year to fifteen months, but the high level of inflation will remain and drive further demands for inflation busting pay demands in the public sector.

Furthermore, she went on to say that she remains mindful of the interest rates decisions being made by the country’s G7 partners and the fact that rising inflation is an issue for the global economy that has arisen primarily as the world has exited the Pandemic.

Mann acknowledged that there is a degree of interconnectedness between economies, particularly in the developed world, due primarily to the growth of digital communication and instant money transfers.

There is also the potential for Sterling to weaken significantly if the UK is seen as being overly dovish over inflation. While every country has its own economy to protect, a significant erosion of the value of the currency also has inflationary implications.

A survey published yesterday showed how the UK property market is being damaged by the continued hikes in interest rates. The latest CIPS survey of activity is the construction industry fell to 48.4 from 48.8 previously. This shows that activity is contracting, and will continue to do so as potential home buyers shy away from rising mortgage rates.

There is some better news for the property market on the horizon as confidence in the UK is returning following the near decimation it suffered from Liz Truss’ ill-advised rush for growth last summer.

The latest IMF global economic report commented that although the UK faces having the poorest performing economy in the developed world this year, the policies of the current government are both sound and built on solid foundations.

The pound appears to be bottoming out following its data induced fall on Friday. Yesterday it fell again, but only marginally, reaching a low of 1.2005 and closing at 1.2023.

There is a strong feeling within the financial market that the FOMC will remain true to its word and continue to hike interest rates while economic data continues to show inflationary factors remain.

It is often considered a glib expression from Central Bankers that they are data-driven as a way of saying that their hands are tied over interest rates. The implication is that although, in the Fed’s case, their mandate is to pursue maximum employment and price stability, economic reality means that they have to favour one over the other.

While inflation is gradually falling and the jobs market remains red-hot, the FOMC is looking a little further down the road at what effect an employment market that can still create over 500k new jobs in a month when recession fears still remain will have on inflation.

The twenty-five basis point hike that was agreed last week appears to have been an outlier within the Bank’s overall monetary policy, and Jerome Powell was clear that it is way too early to declare the war with inflation over. The intimation is that an increase to fifty or even seventy-five basis points could return if inflation remains stubbornly high.

Other members of the FOMC feel that with the fed funds rate targeting a range of 4.5% to 4.75% when it was at zero a little year ago, that despite another increase was warranted it should be smaller and the effect of rates now being in restrictive territory should be closely monitored.

The dollar continued its rally that began with the stronger than expected employment report on Friday. It climbed to a high of 103,76 yesterday, closing at 103.63. It faces resistance around the 104 level, and it is open to question whether having seen the jobs report and a mildly hawkish FOMC meeting whether it will have sufficient momentum to rise much further.

Today will see the release of the trade report for January. This data has lost significance since employment has become more relevant to the economy. It is expected to show the deficit has risen to around$68 billion, and unless the numbers are significantly out of line the effect on the dollar is likely to be minimal.

The European Central Bank now carries the mantle as the most hawkish Central Bank, certainly within the G7 and possibly in the developed world.

The readiness of several Eurozone countries to continue to push for higher-short term interest rates, particularly even though inflation is beginning to fall and has certainly topped out, means that the current cycle will continue until at least May, although that is only two meetings away.

While their hands are tied over monetary policy, the more indebted members of the Eurozone still have a free rein to affect fiscal policy, and that is the reason that Christine Lagarde’s call for support payments for energy costs should now begin to be dialed back.

Although Italy has now accepted that interest rates are going to continue to rise, as evidenced by the comments last week from the head of the Central Bank, the Government remains committed to providing as much support to its people as possible.

As mentioned yesterday, retail sales fell in January as concerns over the rise in interest rates hit consumers. That data was offset to a certain extent by rising investor confidence as the threat of a recession fades. Although investor confidence remains negative, the size of the fall has moderated significantly.

With gas prices having fallen by around 80% from their highs, the Eurozone can expect another leg-up in the coming months, despite an expected escalation of the war in Ukraine, although there are continued issues with domestic demand.

Export volumes have recovered to a healthy level, but overall, across the entire region, but particularly in Germany, France, and Italy, the three largest economies domestic demand is lagging.

A recovery based on exports rather than domestic demand may present a problem due to the fact that the global economy is constantly evolving and can at times be an unreliable vehicle for growth.

In Q4, lending demand was sluggish at best and banks are still being cautious given the bad debt overhang they have and the pressure being exerted by Brussels for them to clean up their balance sheets.

The euro has settled after something of a rollercoaster ride last week. Yesterday, it remained reactive to dollar strength. It fell to a low of 1.0709, closing at 1.0729. While it is unlikely to test the 1.10 level again in the near future, the more hawkish stance of the ECB, makes its medium term fate look more positive.

Have a great day!