3 March 2022: Pay rises to fuel inflation

Pay rises to fuel inflation

3rd March: Highlights

  • Rate expectations send sterling higher versus single currency
  • Fed to go ahead cautiously considering Ukraine invasion.
  • Eurozone inflation hits 5.8%

Bank of England could risk economy to beat inflation

The Bank of England, now fully focussed on fighting inflation, may have to risk taking the economy close to a recession if it is to bring price rises under control.

The next MPC meeting is being held the week after next and although it is uncertain if a third consecutive hike will take place, the mood of MPC members has turned decidedly hawkish.

MPC Member Silvana Tenreyro spoke yesterday of her expectation that the latest increase in oil prices will increase inflation and dampen economic activity.

Although there is little evidence currently of a wage/inflation spiral developing, the Bank will need to take the possibility of this emerging in the coming months if it is to remain ahead of the curve.

Tenreyro believes that there was some evidence that bottlenecks in supply chains were beginning to ease before the invasion of Ukraine began.

Rishi Sunak, the Chancellor of the Exchequer, spoke yesterday of his concern that the UK’s public finances are vulnerable to the conflict as inflation rises and growth begins to slow.

Sunak will make his Spring Statement on March 23rd, and he is not expecting to make any significant changes to the Budget he announced last November, since the deficit for the current financial year is lower than had been predicted.

The Parliamentary Treasury Committee, whose report Sunak was responding to, expressed concern that Sunak’s decision to raise National Insurance contributions to allow increased funding to the NHS will drive inflation higher as wage claims rise and companies raise their own prices for goods and services to protect their own margins.

Sunak went on to comment that the country’s current elevated level of debt makes it susceptible to changes in the macroeconomic outlook. Rises in rates means that the level of funding needed to service that debt also rises.

The pound fell to a low of 1.3271 yesterday but managed to recover to close higher on the day at 1.3400, as volatility created by the conflict in Ukraine continues.

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The Ukraine conflict will hit growth and inflation

In his testimony before congress, Fed Chairman Jerome Powell spoke of the determination of the FOMC to remain on course with its intention to begin to raise rates at the next meeting, despite the significant turbulence that has developed in Financial Markets.

Powell’s preference is for a twenty-five-basis point hike but realizes that this is at odds with some of his colleagues, who are a little more hawkish and wish to front-load hikes to combat inflation. Powell is also concerned about the effect on growth of the conflict in Ukraine and believes that gradual hikes will be more conducive to supporting the current level of growth.

He confirmed that the changes necessary to tackle inflation will take some time to complete but was not drawn on the question of how high rates will need to go due to the current global volatility.

Powell acknowledged that inflation, having leapt to 7.5% compared with one year ago, is unacceptable and is certain to lead to increased wage demands. The Fed cannot expect workers to take a significant cut in real wages, and the Central Bank if braced for wage claims to become another source of inflationary pressure.

A number of Powell’s FOMC colleagues were out in force yesterday, making their own views clear.

Chicago Fed President Charles Evans spoke of extremely high inflation needing to be countered by tighter monetary policy. He believes that labour markets will remain strong. Tomorrow’s Employment report for February is predicted to show that 400k new jobs were created last month. The market will also be interested in the level, if any, of any revision of the January figure.

St Louis Fed President James Bullard reiterated his recent calls for the Fed to act rapidly to call for the normalization of monetary policy to take place as quickly as possible, since this will be the most beneficial method of reducing inflation over the longer term.

Bullard believes that the effects of the war in Ukraine will be significant for the U.S. but that will not be as serious as what could happen to the Eurozone economy.

The dollar index continues to benefit from the current flight to safety.

Yesterday it rose to a high of 97.83 but ran into selling pressure and fell back to close at 97.35.

Rising inflation and falling output to provide a major concern

The Eurozone economy will face considerable disruption from the conflict in Ukraine, with another refugee crisis about to begin.

Brussels has confirmed that it will begin to consider Ukraine’s application to join the EU, but it must guard against undermining its own rules for allowing entry, which are based upon economic rather than humanitarian considerations.

Luis de Guindos, the Spanish Minister of Economy and a member of the Governing Council of the ECB, spoke yesterday of his belief that it is too early to assess the full effect of the conflict, which he believes will have a major dampening effect on activity as well as pushing inflation higher.

ECB Chief Economist Philip Lane is one of Christine Lagarde’s most trusted lieutenants. However, he is still cautious in his outlook, often commenting on what the ECB can do to protect monetary stability without ever predicting when that may need to happen.

Yesterday he spoke of the ECB’s orientation towards medium term inflation, which allows for some short-term deviations from target.

While acknowledging the short-term implications for inflation, he does not say what action may be necessary to protect against further major price rises that will affect the medium-term outlook.

With the rate of inflation rising again in Germany, there is sure to be some backlash at the next ECB meeting, but for now the new Bundesbank President is going to have to accept the consequences of recent ECB inaction since there is no chance of either a natural or implied change.

Fears concerning stagflation are continuing to do the rounds. The issue is that the condition will have already arrived before any measures to counter it can be enacted.

Inflation is an obvious feature, since price rises are an everyday factor. It is less easy to visualize falling output or other economic activity, particularly as it impacts the entire community.

The euro remains in a battle to avoid a drop through the 1.10 level.

Yesterday, it fell to a low of 1.1057, but managed to recover, as short positions were liquidated, to close at 1.1127.

Have a great day!
About Alan Hill

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.”