- Inflation falls, but less than expected
- Debt ceiling not a factor in dollar’s recent rise
- ECB policy may be more affected than expected by economic headwinds
Inflation is likely to fall by even more in May
The market was expecting the fall to be even greater at 8.1%. This means the likelihood of the Bank of England hiking interest rates again at its next rate-setting meeting is more likely than previously expected.
Core inflation, the rate with more volatile items like energy and foodstuffs stripped away, rose in April to 6.8%, up from 6.2%.
This was the outcome that Andrew Bailey, the Bank’s Governor had warned about last, when the spike about a wage/price spiral, where headline inflation begins to fall, but the core is propped up by the lag in wage settlements that were negotiated while inflation was far higher and only now are coming into force, beginning.
The data chimed with the IMF report published the previous day which predicted that the UK would avoid a recession this year, but that inflation would remain stubbornly high.
The “word on the street” following the last meeting of the Monetary Policy Committee was that a pause in the cycle of rate hikes could now be considered, but the rise in core inflation now appears to have set that back.
The disappointing fall in headline inflation was entirely due to considerable increases in the price of basic foodstuffs like milk and sugar.
Interest rates are expected to climb to 5% by the end of the year, as the Bank of England tries to dampen demand. This becomes more difficult than when it is the price of items that are considered essentials that are increasing almost week to week.
The likelihood of further interest rate rises will bring further pain to homeowners who are likely to see the rate on floating rate mortgages rise at least twice over the second half of the year.
The data has led to a mixed week for the economy, following the IMF’s assertion that the Government has put in place the conditions for a sustainable recovery.
There remains a possibility that a further rate hike or two will see the Bank of England reach the goal set by the Prime Minister of halving the fate of inflation this year. A Headline rate of 5.3%, half of what it was when he came to power is now eminently possible.
Yesterday the pound dropped below its medium-term support due to the headwinds created by the release of the minutes of the latest FOMC meeting and continued concerns about the debt ceiling in the U.S.
It fell to a low of 1.2332, and closed at 1.2334.
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Less support shown for further rate hikes
With the meeting having taken place three weeks ago and with the “picture” of the economy changing rapidly as speculation about the debt ceiling continues.
The possibility of a recession and a slew of corporate results are released, mean that the minutes are in danger of being lost in the maelstrom of information that has become available since the committee met.
The overriding outcome of the latest FOMC meeting was that there is less support for further rate increases than there has been at previous meetings.
It was agreed that the need for further rate hikes is now less certain than it has been since the start of the year, and the latest twenty-five basis point hike might be the last.
A few members of the committee who may be considered hawks, cautioned that the Central Bank needs to keep its options open and not “paint itself into a corner.
That mood was reflected in the comments of the President of the Minneapolis Fed, Wael Kashkari recently when he said that while he was leaning towards a pause, he felt that it was too soon to issue a definitive statement that the cycle of hikes had come to an end.
There was no change in Fed economists’ view that the country still faces a mild recession this year. It is unclear if there is any caveat attached to that, that changes in monetary policy will change its basis.
The FOMC all agreed that the rate hikes that have taken place since the start of the year are having a material difference on demand. The overriding belief among most members was that there is still a need for optionality and that the next move should be dictated by the data.
The latest meeting was held a couple of days before the publication of the April employment report, which turned out to be stronger than expected and meant that the Fed was right to hike at that time.
There has been no publicly available evidence that the debt ceiling issue is any closer to resolution, although there is clearly a lot of work taking place behind the scenes as the deadline approaches. The market remains “twitchy” with risk appetite continuing to wane, which is providing support to the dollar index.
The “mixed bag” that the FOMC minutes provided was considered neutral to dovish for the dollar’s longer-term prospects, but for now the market is driven by the continuing negotiations.
Yesterday, the dollar index rose to a high of 103.91 and closed at that level.
Bundesbank apparently content to threaten growth
Nagel spoke yesterday about the need for the ECB to raise interest rates “several more times” in order to defeat rising inflation.
Although this is the speech the President of Germany’s Central Bank would be expected to make given its history of hawkish comments, it provided a graphic image to the market of what to expect over the next quarter and a half.
There is now a real possibility that the ECB won’t pause its cycle of rate hikes before the end of the year, although analysts now see that happening at the end of the third quarter.
While some of Nagel’s more dovish colleagues on the Governing Council are saying that the cycle of fate hikes is coming to an end, Nagel insisted that there is significantly more tightening of policy “in the pipeline”.
He went on to say that even when the ECB agrees to a pause in rate hikes, short-term rates will need to remain at a heightened level for some considerable time.
This sentiment was echoed by French Central Bank Governor, Francois Villeroy de Galhau who commented that once the ECB agrees to pause rate hikes, the key issue will be how long they will need to stay elevated.
With inflation still running at 7%, the answer to the question of any meaningful fall in core inflation may not be seen until late autumn.
The current prediction is that the ECB will be in a position to cut rates to stimulate the economy sometime in the first quarter of next year, but given the current rate of inflation and the pace of its downward path, that prediction may quickly become over-optimistic.
The euro remains under pressure from the current bout of dollar strength. Yesterday it fell to a low of 1.0748, closing just one pip higher at 1.0749.
Have a great day!
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24 May - 25 May 2023
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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.