- At last! The Bank of England surprises the market
- The economy continues to grow, absorbing the brunt of tighter monetary policy
- German economy to shrink by more than expected this year
Bailey warns of “unsustainable” wage increases
This was most likely in reaction to the May inflation report, which was released the previous day and showed that headline inflation was unchanged at 8.7% while the core actually rose to 7.1% after a reading of 6.8% in April.
The base rate of interest is now at 5%, its highest level for fifteen years.
The market, although taken aback by the newly hawkish stance of the Bank, appreciated that it was taking the lead in the fight against rising prices after an extended period in which it made a series of almost grudging “dovish hikes” each of twenty-five basis points.
This contrasted with the more proactive stance taken by the ECB and FOMC, each of which have hiked rates in larger increments over a similar period.
Andrew Bailey, the Governor of the Bank, was more animated than he has been over the entire period of his tenure as he spoke of the need to curb unsustainable wage increases and firms trying to support profit margins by “inappropriate price increases for their products.”
There is little doubt that Bailey has not been a universally popular Governor since he replaced Mark Carney, although it must be remembered that he began just as the pandemic was starting and has faced a litany of tough decisions.
He retains the support of the Chancellor, who spoke recently of the lack of options the MPC faced as inflation rose, close to becoming out of control.
When questioned about whether he would welcome a recession as a means of bringing inflation down closer to the Government’s 2% target, Bailey appears to hint that it “wouldn’t be the worst outcome”.
The market now expects two or three further rate increases this year, with the base rate likely to top out at between 5.75% and 6%.
There was further outcry about the rate increases that mortgages are going to see over the coming months. Despite calls for the Government to step in to help, this situation bears truly little comparison with what happened during the Pandemic.
The nature of the market has changed irrevocably over the period since rates rose in a similar fashion, with a significantly higher number of fixed-rate options being taken up by borrowers.
This has changed the extent to which rate increases have an “instant” effect on inflation, but now the luxury of paying a fixed rate while short-term rates have risen is coming back to bite borrowers.
The Government may be able to encourage lenders to allow borrowers to extend the tenor of their loans, which would reduce their monthly payments, or switch to a floating rate which would eventually see payment fall as rates eventually stabilize or begin to fall.
The pound initially rose to a new high for the year at 1.2845 in the wake of the announcement from the Bank of England, but it quickly subsided to close at 1.2745.
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A soft landing is eminently possible
The Market has been expecting that the headline number for new jobs created would begin to fall even before the record of 500k+ was seen in January.
Indeed, the May NFP number was still the second-highest seen so far this year.
The FOMC believes that the economy is sufficiently resilient to withstand further rate hikes this year, once it has had a chance to evaluate the effect of the pause that took place following this month’s meeting.
The strong labour market was the biggest surprise that has been delivered by the economy during the current period. Powell believes that the labour market is “gradually cooling” and that is to be welcomed.
A soft landing or at worst a mild recession is the most likely outcome for the recession in this period while interest needs to be raised.
Some economists still believe that to achieve a 2% core rate of inflation, the unemployment rate will need to reach around 10%. That theory has so far been debunked, but rates have not yet reached even a neural level, far less being restrictive of demand.
Several members of Congress expressed their concern that further rate hikes would do more harm than good. The pause was welcomed, although there was an underlying view that, as was said in the wake of last week’s announcement, it is only temporary.
Powell reiterated that the concern for the FOMC is that it will go too far, which is why as rates reach neutrality it intends to go forward carefully.
The Fed remains data-dependent, so the outcome of the June employment report will be scrutinized as will the latest inflation data.
The dollar index made ground yesterday, as it moved away from the support level below 102. It reached a high of 102.46 and closed at 102.40.
Lagarde refuses to name a “neutral rate”
ECB President Christine Lagarde refused, when questioned yesterday, to speculate about when eurozone interest rates would reach the neutral level, while a lengthy period when they will be restrictive is being called for by the more hawkish members of the Governing Council.
The decision to be taken at the September ECB meeting on interest rates is creating a large amount of discussion.
It is a measure of the authority of Lagarde, although he does have the backing of the five most hawkish Central Banks, that since she announced that a further hike is “very likely” at the July meeting all discussion about a pause has ceased.
There are two very distinct sides developing currently which are being led by two members of the Governing Council who don’t, or at least shouldn’t have any side to promote other than the good of the entire Eurozone.
Isabel Schnabel is a confirmed hawk on monetary policy. She spoke earlier this week about the need for the ECB to “overhike” going forward to ensure that inflation falls to, or even below, the target.
The target is an “average” of 2%. When it was changed from 2% as an absolute figure, it was felt that the ECB became a little “lenient”, since inflation had been below the earlier target for an extended period. Now having been significantly above 2% for a period, Schnabel believes that the ECB should aim for a fall to below 2%.
Meanwhile, Philip Lane, a former Governor of the Bank of Ireland, now the ECB’s Chief Economist believes that if the ECB is to be truly data-driven that there should be consideration made prior to any decision being usurped.
The discussion about the “September hike “ will have a very long lead-in period, since following the July meeting the European holiday season will begin in which the “hawks of the north” will be able to see first-hand the effect of higher interest rates and high inflation is having on the nations of the south.
Although the Euro has been gathering strength from the hawkish nature of the ECB recently, this week it has been driven by events elsewhere. Yesterday, the common currency reached a high of 1.1012 but lacked any follow-through and settled back to close at 1.0955.
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Alan has been involved in the FX market for more than 25 years and brings a wealth of experience to his content. His knowledge has been gained while trading through some of the most volatile periods of recent history. His commentary relies on an understanding of past events and how they will affect future market performance.