10 January 2024: A prolonged recession may be the result of any delay in rate cuts

The Government of Rishi Sunak has been “disaster-free” for several months, and while there are still legacy issues around migration and the NHS, overall the public is beginning to see the potential in a Conservative Government that can plan for the future of the economy as inflation falls and Brexit and the Pandemic become “rearview mirror issues”.

There is even a growing sense of optimism in the City that when the data for the fourth quarter is published, the country may have escaped being in a recession.

There is still a long way to go before the country is on a path to sustainable growth, but if the election is to be fought with the economy as the main issue, the Conservatives would appear to have given themselves a “fighting chance.”

The focus of financial markets criticism has firmly switched to the Bank of England, with economists being heavily critical of the role Andrew Bailey played in allowing inflation to rise above double figures, while the rest of the permanent members of the Monetary Policy Committee have been accused of “groupthink”.

Going forward, the MPC will need to be more proactive in agreeing on rate cuts to ensure that a developing improvement in output continues and employment data is still positive.

Bailey has been “absent” since well before the Christmas period, at a time when he should be at the forefront, exuding confidence in his team’s ability to drive the monetary policy forward.

There is a “them and us” scenario that has developed over the past six months or so, with the independent members of the Committee making comments that are far more hawkish than those of the permanent members.

MPs are beginning to make dissatisfied noises about the makeup of the MPC, as the independent members have become like children in the fifties, “seen but not heard”.

The Prime Minister and his Chancellor will be working hard on the budget, which is now under two months away, and will surely mark a significant step in the election preparations.

Although Sunak has said that the expects the election to take place in the second half of the year, there are very few certainties in politics and if there is a sense of complacency or unpreparedness noted in the opposition, which is still not providing details of how it plans to fund its spending plans, then it may very well be that an election is called sooner.

The market is still unsure of the path it expects Sterling to take in the coming year. There are still several uncertainties with the election, rate cuts, tax cuts and the performance of other G7 economies all having a part to play.

Yesterday, the pound was primarily driven by the growing view that the Bank of England won’t be allowed to begin rate cuts according to its agenda since cuts appear to be the only way that the economy will be able to achieve any growth at all over the first half of the year.

It fell to a low versus the dollar of 1.2689 and closed at 1.2704.

The market was not only nonplussed by the latest FOMC meeting, but it appears to have taken Jerome Powell’s comments almost out of context, seeing a commitment to rate cuts that simply wasn’t there.

The minutes of that meeting were published in the lead-up to Christmas, and although they weren’t ignored, the market still didn’t take on board the neutrality of the committee.

There have been several comments from FOMC members since, and none have shown any form of commitment to when rate cuts to begin.

With a strong employment report for December delivered last week and the latest inflation figures, which are due tomorrow, likely to show a small rise in headline price increases even though the core will fall marginally, the window for rate cuts to be delivered in the first quarter is closing rapidly.

When the Q4 GDP data is released on January 25th, it will show that the economy is still growing at a rate which shows that interest rates remain restrictive but not excessively so. This will allow the FOMC to cut rates according to its agenda.

Throughout the second half of last year, the market became obsessed with forecasting when rate hikes would end, and this year that obsession has been reversed to when the first cuts will take place.

Central banks must be given time, whether that is the BoE, ECB or the Fed, for their policies to take effect. This is particularly so since it has been tacitly agreed that changes in monetary policy must be given time to work their way through into the entire economy.

It is still likely that the most recent hike is still influencing output and productivity.

Michael Barr, the Fed’s Vice Chairman for Supervision, gave a speech yesterday in which he hinted that the crisis that threatened to overwhelm several regional banks last year is at an end. He said that the emergency loan facility, which was agreed last year, is unlikely to be renewed.

The dollar index is still in the range that has been in place since the New Year, although yesterday it threatened to break out to the upside.

It climbed to a high of 102.65 but fell back to close at 102.51.

There is a continuing disagreement among members of the ECB’s Governing Council about when rate cuts will begin.

The ECB has been plagued for more than a year by a jingoistic attitude about interest rates, with most members voting for the best outcome for the “home” economies and not for the “common good”.

Yesterday Bank of Portugal Governor, Mário Centeno gave an interview in which he spoke of the likelihood that rate cuts will happen sooner than the market expects.

He said that the May ECB meeting will be far too long for cuts to be considered, since there are no signs of any increase in inflation, that price rises will have reached the ECB’s target by early Q2 and while it has been appropriate for rates to remain constant, a cut will be necessary to revive demand and economic activity.

Meanwhile, the Banque de France governor, Francois Villeroy de Galhau, gave a far more hawkish view. He believes that although the ECB will cut rates in 2024, inflation will not only need to fall to or even exceed the ECB’s target of 2% but will also need to be solidly anchored at that level for a “significant period.”

He went on to say that the ECB’s decisions need to be based on actual data, not expectations. Villeroy appeared to dismiss any form of proactivity in Central Bank decision-making.

There is a clear difference of opinion about when rates will be cut, but if the Central Bank is to be driven by data, then the time for cuts is rapidly approaching, with the Eurozone heading for a recession.

Data published yesterday appeared to pour cold water on the view that the German economy is seeing the first green shoots of recovery.

Industrial production fell by 0.7% in December, down from a 0.3% decline in November. This led to a year-on-year fall of 4.8%, again down from a slightly revised 3.4% in November.

The Bundesbank appears to still favour a mild recession over rampant inflation. But while the rate of price rises is falling, the German economy is failing markedly to respond.

The Euro has tested the lower end of its recent range three times in the past five sessions and recovered every time. Yesterday it fell to a low of 1.0910 and closed at 1.0928. It must surely only be a matter of time before the combination of falling inflation and weak economic activity sees it begin a long march lower.

Have a great day!