21 September 2023: Sunak softens the UK’s green agenda

The August inflation report was published yesterday, and it showed that both core and headline inflation fell unexpectedly last month. The significant rise in fuel prices over the past six weeks or so has been offset by falls in other areas, primarily foodstuffs.

It is unclear whether the fall in inflation will influence the Monetary Policy Committee which will announce its decision on any change to the base rate of interest later this morning.

Interest rates are at or close to the level at which they are restricting demand, so the MPC will need to “tread carefully” in its decision-making.

There have been calls from both within the committee and from outside observers for rates to continue to rise since inflation remains the highest in the G7 Group of Industrial Nations, despite the economy beginning to falter.

Year-on-year the headline rate of inflation fell to 6.7% from 6.8% a month earlier, while the core rate with volatile items stripped out fell to 6.2% from 6.9%.

The MPC is likely to draw criticism no matter what decision it makes later today. If it confirms another hike, the fifteenth in this cycle, it faces accusations that it is now damaging the economy, while if it pauses, there will be claims that Andrew Bailey and his colleagues are still not doing enough to show they are taking inflation seriously.

The Prime Minister delivered a major policy speech yesterday in which, as expected, he “watered down” Britain’s commitment to achieve net-zero carbon emissions by 2050.

There were two significant policy changes. The phasing out of petrol and diesel vehicles which was due to happen by 2030 has been extended to 2035 while the replacement of gas central heating boilers in domestic premises with heat pumps has been also extended to 2035.

Sunak explained that while the country remains committed to net-zero emissions, the cost-of-living crisis means the costs outweigh the benefit of these two policies.

The announcement was met with criticism from industry leaders. The CEO of Fork UK labelled the move as reversing all the work that has been done already as the market had been “almost ready” to phase out fossil fuelled vehicles by 2030. The Federation of Housebuilders commented that the Government should be at the forefront of green initiatives and should make policies that force builders to comply.

The reaction from Conservative backbenchers was more muted. Overall, they saw the benefits in the short term with a n election looming but questioned the merits of making such sweeping changes.

The pound returned to the weakness that it has seen recently, more in reaction to the fall in inflation than the changes in green energy policy.

It fell to a low of 1.2332 and closed at 1. 2344.This is the lowest it has been in this quarter and reflects the imminent end of interest rate support for the currency.

The latest meeting of the FOMC concluded last evening with the committee announcing another pause in interest rate hikes. This came as something of a surprise to the market given that inflation rose by more than expected last month.

We will have to wait for three weeks until the minutes are published to find out what the thinking was behind the latest pause.

Also, as part of this meeting the Fed published its expectations for interest rates up to three years hence. These were higher than they had been previously with one year hence being increased from 4.6% to 5.1%, two years hence to 3.9% from 3.4% and three years 2.9% from 3.1%.

This shows that the Fed expects rates to remain higher for longer and persuaded the market to accept that the first cut in rates will be further into the future than previously believed.

The overall outcome of the FOMC meeting was that it had been a “hawkish pause” since Jerome Powell again announced that the committee expected to need to hike rates again before the end of the year.

Rates will remain at a twenty-two-year high at least until the second quarter of next year unless the economy takes a significant turn for the worst, which is not the current thinking in the market.

In his press conference following the decision, Powell confirmed that a soft landing remained the committee’s primary objective.

This was a subtle but meaningful change to his recent rhetoric in which he had constantly said that driving inflation was and will remain the main purpose of changes to monetary policy.

The market believes that the Fed may not have enough room to hike again this year despite Powell’s comments if they are truly committed to a soft landing given the lower output data that has been seen recently. A lot will depend on the employment reports going forward.

The dollar index reacted positively to the pause. It rose to a high of 105.68 and only a late bout of profit taking saw it finish moderately lower at 105.54

The harmonised rate of inflation for the Eurozone fell to 5.2% in August, down from 5.3% a month earlier. The relatively small fall went some way to justifying the hike that was announced by the ECB last week.

The Harmonized index applies an identical “basket” of goods and services to every member country and while it shows the average, the highest and closest rates of inflation in the region are not considered relevant.

This leads several actions to adjust their fiscal policy to consider the actions of the ECB.

Only a handful of countries have inflation rates that even approximate the harmonised rate which makes the changes in monetary policy based on it more than a little spurious.

For the time being, more Eurozone members have core inflation rates that are above the average than below, but that will change going forward.

There is some justification to only using the “middle” section of nations since there are ingrained reasons that, say, the Baltic States will always have significantly higher inflation than the rest of the Union given their geographical position and the scarcity that this led to of several key staples.

Since the minutes of the meetings of the Governing Council of the ECB are not published, there is a high degree of speculation about what drove the decision to hike again.

The main contributors to that decision would have been the Austrian and Latvian members, but it was what was said by the German, Dutch and Belgian contingent, two of whom had been more dovish in their comments prior to the meeting, while the third had avoided the subject entirely.

With inflation having been benign throughout the entire history of the Union, the fact that rates are at historical highs should not come as a surprise.

However, the ECB is creating a benchmark for the level rates will need to reach the next time that there is a major “flare-up” in inflation.

The euro remains on its long march towards parity. Yesterday, it fell to a low of 1.0617, closing at 1.0634.

The long term support remains in the mid-1.05s which may take some time to break, but the evidence is that monetary policy is no longer providing the support it was, so unless there is a major upturn in activity and output leading to stronger than expected GDP numbers, the Euro looks doomed to fall to new lows for the year.

Have a great day!