6 February 2025: Reeves is braced for unwelcome news from the OBR

Since the start of the year, members of the Bank of England’s rate-setting Monetary Policy Committee have been curiously quiet, with only the bank’s Governor, Andrew Bailey and the committee’s newest member, Alan Taylor, speaking in public about the prospects for interest rates either today or shortly.

This has led to significant speculation about the path for interest rates, with several commentators making judgement calls which have varied, sometimes considerably.

A rate cut today is still difficult to judge based solely on the data, without considering whether the Committee wants to act preemptively or reactively.

There is little doubt that the Chancellor would approve of a cut today and a signal that monetary policy will continue to be loosened during the first half of the year. It is impractical for a Central Bank to consider the path of interest rates more than six months in the future, particularly given the current uncertainties in the global economy.

However, inflation is still above the Bank’s 2% target, even though it briefly touched that level late last year. The more hawkish members of the Committee, Catherine Mann in particular, will be hard-pressed to make a case for another wave of secondary inflation since wages, particularly in the private sector, are levelling off.

Of course, the Government could bow to the pressure from public sector unions and agree to above-inflation increases for train drivers, teachers, and local government employees without seeking productivity assurance, but that would be self-defeating for a government desperately seeking growth.

No one should be surprised by today’s interest rate decision no matter which way it goes, it is literally on a knife edge.

The OBR delivered its official growth forecast to Rachel Reeves last night. If it goes the way of every other estimate, the Chancellor is operating with much less ‘headroom’ than she predicted. It is expected that Reeves received more unwelcome news about the prospects for growth this year, and this will lead to her having to make tough decisions in preparation for next month’s spending review.

It may come down to a straight choice between spending cuts and increasing taxes. She has already ruled out the “third path” which would entail increasing her self-imposed limit on the level of Government borrowing.

Reeves finds herself in the same position as many of her Tory predecessors: tightly constrained by her own “iron-clad” fiscal rules and with the government’s fate dependent on the decisions of three relatively unknown officials in Westminster.

After her October budget, which included rises in tax and public spending, Reeves was left with £9.9 billion of fiscal headroom, effectively a cushion against her spending plans.

J.P. Morgan, Goldman Sachs and leading economists believe that headroom is now gone.

The pound broke above its short-term level of resistance yesterday, reaching a high of 1.2550.

However, it fell back later in the day to close at 1.2502.

The Federal Reserve is still leaning toward further rate cuts this year, although uncertainty about the impact of new Trump administration initiatives on things like tariffs, immigration and regulation will need to be better understood, Richmond Fed President Tom Barkin said on Wednesday.

While the markets have been spending time considering the likely ramifications of Trump’s threat to impose tariffs on U.S. imports of finished goods, when he turns his attention to deregulation of the economy, particularly giving less control to the Federal Government, analysts will face a whole new set of problems.

His cabinet will have to show some fortitude to explain to the President that he cannot “have his cake and eat it too”. It is almost a straight choice between lower interest rates and lower inflation.

Along with tariffs, there is deregulation coming, where it is going to be applied, to immigration, energy policy, and geopolitics. There is just a lot of uncertainty in the air," Barkin said yesterday.

But with inflation expected to drop further this year and the economy continuing to grow, "I start with a baseline that is pretty favourable" to further cuts, Barkin said. "That is certainly the current bias."

Barkin's comments reflect what's become a consensus view at a Central Bank that has decided to hold its interest rate policy steady while it awaits further data on jobs and inflation and on the outcome of Trump administration policy initiatives that may be hard to anticipate.

The latest report from ADP suggests that the robust growth trend in the US labour market is continuing. According to the data released yesterday, the private sector added 183 thousand jobs. Last month’s data was revised up by 54k to 176k. Job gains have accelerated since last August, roughly coinciding with the start of the Fed’s rate-cutting cycle.

With so much concentration on the President’s plans for foreign trade policy, speculation about the January employment numbers has almost fallen by the wayside.

There is no reason for the headline number to be anything other than solid when it is published tomorrow.

While many market practitioners believe that job creation will be the first to be hit when the economy begins to cool, there has been no sign so far that anything untoward is about to happen.

The service side of the U.S. economy, in which most people work, cooled off in January, as did inflation, but cold weather at the start of the year had something to do with it.

The service index compiled by the Institute for Supply Management slid to 52.8% in January from 54% in December. Most businesses supply services, and more than 80% of American workers are employed by those businesses.

“Poor weather conditions were highlighted by many respondents as impacting business levels and production,” said Steve Miller, chair of the survey.

The best news in the report was some easing in inflation, although price pressures were still a problem.

The dollar index fell again yesterday, reaching a low of 107.31, although it closed at 107.61 having briefly looked like challenging its short-term support level as 106.90.

While the market must consider any more unexpected comments from President Trump, its eyes will now be firmly fixed on today’s jobless claims data as a prelude to tomorrow’s jobs report.

There have been many false dawns for the Eurozone economy, where it has looked to have bottomed out. The difference in the latest data is that the ECB now appears to be concerned about a continuation of the decline and is prepared to loosen monetary policy to provide a little support.

Economic activity returned to positivity in January following five months of decline, according to estimates from S&P and the Hamburg Commercial Bank, which compiles the data.

The composite purchasing manager’s index rose to 50.2 last month after a reading of 49.6 in December. It was the first time it has been above the 50 level, which is considered “neutral” since August.

While Eurozone inflation ticked up slightly in January to 2.5 per cent, edging higher for a fourth consecutive month driven by energy price increases, the ECB is expected to turn a blind eye as it has decided to promote growth, apparently as long as inflation remains close to its target level.

Consumer prices were up from 2.4 per cent in December 2024, slightly disappointing analysts. The consensus had been that the headline rate would be unchanged.

Even the decline in Germany's manufacturing sector eased in January, helped by the slowest fall in both output and new orders in months. Possibly, even Germany’s economy is bottoming out, despite the structural issues that will continue to plague it no matter who wins the election, which is approaching fast.

However, French factory production unexpectedly dropped at the end of the year, contributing to a backsliding in the eurozone’s second-largest economy, with few signs of a rapid rebound at the start of 2025.

Total output of goods was 0.7% lower on the month in December, reversing a slight increase in November, statistics agency Insee said Wednesday. That was a worse result than the stagnation forecast by economists, according to a poll compiled by The Wall Street Journal, and means output decreased in seven out of 12 months last year.

The transportation sector saw a steep drop in December, with an 11% fall in automobile production, a fresh blow to Europe’s beleaguered carmakers, who are unlikely to receive any better news when President Trump announces tariffs on European exports to the U.S.

Other key areas including pharmaceuticals also booked heavy reductions in output over the month.

For France, there is hope that greater political stability might brighten the mood for industrial employers and investors as the year progresses. Prime Minister François Bayrou survived a confidence vote in the French legislature on Wednesday, having earlier this week forced through a budget after months of delays.

Bayrou survived courtesy of Marine Le Pens's far-right group. Bayrou survived two no-confidence votes on Wednesday night after the National Rally decided against toppling the government over its budget.

But even a better-functioning government can’t rescue France from its economic malaise, Commerzbank economist Vincent Stamer warned. Growth in the French economy last year was spurred by state spending, but the government must now tighten its belt drastically.

The Euro is faring a little better, but traders are buying with teeth firmly gritted as they await news on what tariffs will be imposed on Eurozone exports to the U.S.

The single currency rallied to a high of 1.0442 but drifted back to close at 1.0402.

Have a great day!