26 September 2023: Too many for too long

Members of the Monetary Policy Committee are facing criticism for continuing to hike interest rates, potentially causing damage to the economy, when a pause should, or could, have been agreed earlier in the year.

It is agreed that changes to monetary policy take up to three months to work their way through the economy. Therefore, a pause earlier in the year would have been effective in allowing the economy to “catch up” and would have provided some relief to people struggling with the cost-of-living crisis without seriously damaging the fight against inflation.

Publicly, Jeremy Hunt and his colleagues at the Treasury have supported Andrew Bailey in his battle to bring inflation down, and it remains possible that the Government’s pledge to halve the rate of inflation by the end of the year may still be fulfilled.

However, the cost to the economy may have been too high a price to pay, particularly if the country falls into a damaging recession either later this year or early next.

It is believed that irrespective of the pause that was announced last week in the Bank’s cycle of interest rate hikes the economy is likely to grow at an even slower pace in the second half of the year if it registers any growth at all.

The latest employment data showed that the claimant count is beginning to rise. This is a direct consequence of the tightening of monetary policy, while rate hikes are having a similar effect on the property market which is experiencing falls in both prices and activity.

It may very well be that the pause announced last week is, in fact, the end of the programme of hikes although no one expects the Bank to confirm this while inflation remains above target.

The effect of last week’s pause on the currency has been negative, although Sterling was already seeing renewed weakness which is seen as a combination of the effect of “still too high inflation,” the prospect of a slowing economy, and the effect of comparative monetary policy with the rest of the G7 group of industrialized nations.

Yesterday the pound continued its recent bout of weakness. It started the week on the back foot, falling to a low of 1.2193 and closing at 1.2211. The only relevant data due for release this week is the Nationwide Index of housing market activity, due to be released on Thursday. This is expected to see a continued fall in both prices and activity.

The FOMC may very well have had some advance warning of a significant slowdown in activity in the employment market which may very well have tipped the balance between growth and inflation at its meeting last week and push most of its members towards a second pause in three months.

Jerome Powell is not about to confirm that the cycle of hikes has ended when there is a real possibility that the continued rise in the oil price may see the headline rate of inflation spike this month or next.

There is no doubt that it is a sensible use of policy to keep the market guessing by only providing advance guidance that is useful to the committee’s deliberations.

Neel Kashkari, the President of Minneapolis Federal Reserve, spoke yesterday of his surprise at the resilience of the economy, and for this reason he expects one further rate hike before rates reach their peak.

Not only will there be another rate hike, but he sees any cut being delayed for a longer period than the market expects to counter inflation which may well remain above the Central Bank’s target for longer than was originally expected.

Kashkari confirmed in his speech that he may be considered to be one of the Fed’s more hawkish policymakers and while he may not have agreed with last week’s pause, he is able to see the logic in allowing the market and the economy some breathing space in which to catch up with monetary policy.

The current expectation is for the Fed Funds rate to still be at or at least very close to 5% at the end of next year, but there are still some hawks who feel that rates will hit 6% before any cut is possible.

Kashkari’s colleague Austen Gooslbee spoke yesterday of the risks that the economy still faces. While he remains confident that the economy will avoid a recession, growth may remain “difficult to come by” before the end of the year, although he also sees rates remaining “higher for longer.”

The dollar index is currently the “only game in town” as far as the market is concerned. It made another fresh high yesterday, reaching 106.09 and closing at 105.95.

With the market now focusing on expectations for relative rates of prospective growth for G7 nations, there is extraordinarily little reason not to expect the dollar’s bout of strength to continue.

Christine Lagarde makes no apology for her view that the third quarter of the year is unlikely to see an improvement in terms of output, economic activity, or growth over what has gone before so far this year.

Lagarde believes that the market must accept that a significant majority of the Central Bank’s Governing Council still sees inflation as too high and a major issue for the stability of the Eurozone.

For this reason, there is no reason to make empty promises about when rates will peak, although she does concede that the peak is not too far away.

Despite this, the Bank will not rush into any cuts in interest rates until price increases fall close to, or even below the 2% target.

In a speech yesterday, she also reiterated that rates would remain restrictive for as long as is deemed necessary.

To concede that rates have now reached restrictive territory is a significant departure for Lagarde who had previously said that she felt that rates were neutral, neither accommodating nor restricting demand.

She went on to speak of the difficulty in creating monetary policy that suits all twenty nations of the Eurozone. He also thanked the more dovish members of the Council for their patience and understanding, and that the only way the Union may be stronger is for financial and political goals to be aligned.

French Central bank President Villeroy appears to have become an unofficial spokesperson for the Governing Council, often taking the side of its more moderate members but also putting forward the case for the Bank to be unerring in its fight against high and stubborn inflation.

He spoke yesterday of the futility of the market even considering when the first cut in rates will occur since the Bank is still engaged in a cycle of tightening, no matter how close rates are to their peak.

Taking the “party line” Villeroy also believes that criticism of the ECB is unwarranted, since it is doing no more than acting to fulfil its mandate.

The common currency continued its fall yesterday, although its pace is accelerating. Speculators are still heavy sellers, but their effect is being offset currently by commercial interests looking to “bag a bargain.”

It reached a low of 1.0575 and closed at 1.0593

Have a great day!