10 August 2023: The Government may face a recession in an election year

The National Institute for Economic and Social Research published a paper yesterday in which it flagged fresh concerns about the economy.

The Institute agrees with the IMF and UK Treasury that the country will avoid a recession this year with the economy growing by a paltry 0.3%, but the Bank of England’s projected growth of 1.1% is becoming less and less achievable with every further increase in interest rates.

The NIESR puts the chances of a recession hitting the UK economy in 2024 at 60%. This will come as a blow to the Government since it is due to hold a General Election by January 2025, and a recession is not a good look for an administration that is already struggling with social issues on several fronts.

The paper goes on to say that the country is in danger of losing five years of economic growth because of Covid, Brexit and the conflict in Ukraine.

The “benefits” expected to be derived from the UK’s departure from the EU are barely being noticed since the negotiation of free trade deals is taking far longer than expected with U.S. President, reportedly apathetic to closer ties with the UK, apparently favouring the EU as a far larger trading bloc.

The prices of housing and basic foodstuffs are lonely to remain elevated well into 2024, and this will create greater headwinds for the economy than had been previously believed.

It also believes that the dampening effect of further interest rate hikes, which are sure to be made as inflation continues to fall slowly, will see GDP suffer. There will also be a significant rise in unemployment as firms of all sizes move from “mothballing” expansion plans to actively reducing overhead.

Sterling is likely to remain supported by the continued tightening of monetary policy, but at some point, most likely in the first quarter or possibly earlier, the Bank of England will be forced into emergency rate hikes as the data show a rapid decline in activity.

The government’s plans to level up the economy received a further blow with reports that there is still an unequal amount of investment taking place in London and the South East.

Pay, after taking inflation into account, is falling more rapidly in the Midlands and the North than in the South, which could lead to further industrial action as the next round of pay negotiations begin in a few months’ time.

Sterling remains in a narrow range as activity continues to slide. It fell to a low of 1.2712 yesterday and closed at 1.2719.

Data will be released later today for consumer price inflation in the U.S. for July. It is projected that the headline number will have risen from 3% to 3.3%, while the core, with volatile items like food and energy stripped out, will have remained unchanged at 4.8%.

While this will be considered unfortunate, it will not come as a surprise to the FOMC members who have begun to discuss the outcome of the last meeting of the committee, where interest rates were hiked by 0.25% and their intentions for the next one.

Despite the expected rise in inflation, the expectation is that the Fed will allow another pause in its cycle of interest rate hikes to allow the July hike to work its way through the economy.

Regional Fed Presidents, overall, are favouring a pause, while the only Fed Governor who has spoken expects further rate hikes.

It is fair to say that regional Presidents are closer to the situation “on the ground”, while Governors like Michelle Bowman look at the situation similarly to Jerome Powell in that they take the entire economy into account.

Patrick Harker, the President of the Philadelphia Fed, has already spoken in favour of a further pause, while his colleague at the Atlanta Fed., Raphael Bostic, will speak later today.

He has already said that the current fight against inflation will continue for some time and that the Fed will still be restricting growth well into 2024.

That has been taken to mean that he favours rates remaining higher for longer, which chimes with the comments of Jerome Powell recently, in which he said that the fight against inflation is not yet over but doesn’t necessarily imply that he favours a hike in September.

Bostic is on record as saying that he believes that the increase in infrastructure spending that always accompanies a Presidential Election will also add inflationary pressures.

The economy has created more than 2.6 million new jobs since the start of the Pandemic, and as this begins to slow as restrictive monetary policy continues to bite, inflation will continue to fall, but it is impossible to say that it will reach the Fed’s 2% target before the effect fades.

The dollar index ran out of momentum yesterday as the overhang of sell orders continued to be filled.

It fell to a low of 102.29 and closed at 102.50.

While ECB Governing Council members laze on the beaches of Spain, Italy, and Greece, the issues that they faced over inflation and the outcome of their September meeting shows little sign of abating.

For several months the more dovish members of the Committee have been calmed by the belief that there would be a pause in rate hikes at the next meeting, but that is now by no means certain.

Despite a significant fall in output from the German economy bringing about the possibility that the Eurozone’s largest economy may still favour further hikes, there is a growing view that Christine Lagarde will have to bow to a “dovish majority” and accede to a pause.

If the ECB does pause in September, it will have three major outcomes: 1) inflation will remain at elevated levels, 2) economic activity which has stalled will remain sluggish since rates are already at restrictive levels, and 3) the Euro will slump.

None of these outcomes is particularly attractive, although a weaker Euro may be seen as a benefit to exporters, although any prolonged weakness will see inflation begin to rise.

While the result of the vote is difficult to call, there remain sound economic reasons for another hike even though Italy will make vague threats about the long-term viability of the EU in its present form, and the Monetary Union is an ill-conceived concept.

Even Italy’s Far-Right Government understands the country is better off “inside the tent looking out than outside looking in”, as is being gradually realized by the UK.

There is no doubt that the EU faces a very difficult next six to nine months, so on balance, it may be considered better to get all the bad news out now.

The Italian and French plan to halt hikes immediately and commit to a higher for longer policy still has some merit, but unless Lagarde comes out in favour, it is unlikely to “have the legs” to gain sufficient support from the Governing Council.

The common currency found some support close to the bottom of its recent range yesterday. It rose to a high of 1.0995 and closed at 1.0974. This was the first time in a week that it hadn’t traded above 1.10 at some point during the session.

Have a great day!