11 August 2023: Former MPC hawk sees the end of rate hikes soon

When Michael Saunders was a member of the MPC he was the most hawkish of the independent group. Speaking recently, he spoke of his belief that the Bank will call a halt to its cycle of rate hikes even though inflation is still well above its target of 2%.

A hike in September will probably be the last, but his former colleagues will not be able to begin to cut rates, again due to the lingering issue of inflation. In fact, they will almost certainly trail the Federal Reserve and possibly the hawkish ECB.

Every part of the monetary policy cycle is subject to evolution, and the rise in inflation over the past two years has seen monetary policy work more slowly than in the past. In using almost entirely twenty-five-point hikes the bank has not managed to “get on top” of rising prices.

In the past, there was far less home ownership, but this changed during the “Thatcher years” through her drive to provide the conditions for home ownership to be more common.

Typically, a squeeze on monetary policy now works on households where debt service payments increase substantially, causing them to cut back on other spending. This reduces demand which in turn lowers inflation. Higher interest rates also encourage savings.

However, savers are less prone to alter their savings than debtors, so there was a build-up in debt when rates were low, while savers bemoaned the lack of return on the deposits.

As demand fed inflation and rates rose, rate increases had little effect since they remained well below the “neutral level”. Had they risen more quickly, as has been seen in America, the effect on headline inflation would have been greater.

There has been a tendency for firms to “hoard labour” over the past two years as the effect of Brexit is seen in the availability of low-paid unskilled workers. Productivity has fallen while unemployment has remained low.

The Bank of England is clearly concerned about being blamed for driving the economy into recession, particularly with an election on the horizon, but its “death by a thousand cuts” attitude to monetary policy has been a significant contributor to inflation remaining at elevated levels.

The July data for employment and inflation are due to be published next week.

A further fall in headline inflation is expected, but in keeping with Bank of England policy, the fall will be less than needed. The claimant count is expected to reverse last month’s rise, although the unemployment rate will remain at 4%.

Yesterday, the pound initially spiked to a high of 1.2818, but ran out of steam and fell back to close marginally lower at 1.2676.

Treasury Secretary Janet Yellen has barely spoken in public recently, allowing her colleagues at the Federal Reserve to explain the likely effect of tighter monetary policy.

She is scheduled to make a major speech on Monday, in which she will support the merits of “Bidenomics” which she will say has made a significant contribution to the creation of thirteen million new jobs over the past three years and driving down inflation.

The latest data for inflation was published yesterday. It was projected that headline inflation had risen to 3.3% in July, but there would have been relief at the Central Bank that it only rose by 3.2%.

This will encourage the Fed to leave rates unchanged at its meeting next month, especially if its models predict prices falling again.

Jerome Powell has been strident in recent speeches that the path lower for inflation will not be in a straight line, and although the FOMC remains data-driven, it looks at trends and will be unlikely to react to individual months’ data.

Although headline inflation rose snapping a streak of falls in recent months, underlying price pressure remains moderate, which may well encourage another pause in the cycle of hikes and may encourage Powell to provide further advance guidance on when hikes will finally come to an end.

There was more positive news from core inflation which fell from 4.8% in June to 4.7% in July. Given that volatile items are stripped out to constitute the core, it is to be expected that falls (or rises) are more moderate.

Federal Reserve analysts have warned FOMC members that the economy has entered “uncharted waters”, with the headline rate of inflation falling in line with tighter monetary policy, but with little or no discernible accompanying rise in unemployment that would be expected in such an environment.

This is the first time since the end of World War two that such a set of circumstances have been seen together. Purely anecdotally, perhaps this will also see an inversion of the yield curve not lead to a recession “down the road”.

The dollar initially fell on the news that inflation had risen by less than expected. The index made a low of 101.81, since this may hasten the end of tighter monetary policy, but it recovered to close fifteen points higher at 102.63.

The likelihood that the ECB will pause its cycle of interest rate increases is growing, but without any real reason.

It is undoubtedly “silly season” where financial journalists, under pressure to produce column inches for voracious editors, are prone to write articles that are driven by dubious theories.

The same is true for the outlook for the common currency, but that is at least governed by sound economic reasoning.

The Eurozone economy is weakening rapidly, with two of its major economies, Germany and Italy, both almost certainly in recession, and it is likely that if the ECB remains on its current path that the entire union will follow.

This means that the pressure will be increasing on the ECB to pause the chain of rate hikes at its next meeting, and “hey presto” a story is born.

The fly in the ointment is that the economy has been weakening for some months and the ECB has shown virtually no inclination to pause, other than the pleas from traditionally weaker economies for the paid to stop.

Add to this Christine Lagarde’s virtual indifference to the economy suffering a mild recession if it leads to inflation falling close to the Central Bank’s 2% target, and “rate pause waters” become “muddied” again.

The most prominent relatively new factor pointing to a pause is the state of the German economy.

The German people have so far gone along with their Central Bank’s fascination with inflation, but they will be becoming acutely aware that they saw their savings rates collapse to help more profligate EU members, and now inflation has risen to historical highs and hose same nations are providing more generous help than they are receiving through social welfare.

It has not manifested itself yet, but there may be a growing feeling of nationalism growing, which the Government will have to face to ensure it doesn’t get out of hand.

The Euro rose initially yesterday on a rumour that U.S. inflation had not risen at all. This would have guaranteed a pause in September, but in the end, the more moderate rise left the market unsure, and the Euro fell back. It reached a high of 1.1065 and closed at 1.0981.

The currency will stay in its current range until any monetary and economic divergence between the European Union and the U.S. becomes clear.

Have a great day!