Downside risk outweighs inflation
7th April: Highlights
- Risk of recession rising
- Dollar index at year’s high following FOMC minutes
- Expectations of economic relief fading
The Bank of England may downplay hawkish rhetoric
Inflation is still the focus of the Bank of England, despite growing concerns about the prospect of a collapse in economic activity. The last three MPC meetings have resulted in interest rate hikes and that is expected to continue until rates are double their current level.
It is possible that following the meeting that will be held on 4th August, the Bank will pause to gain a sense of perspective over developments not just in the UK but globally.
Only Deputy-Governor Jon Cunliffe is bucking the trend of interest rate hikes. He voted to leave rates unchanged at the most recent meeting, while every one of his colleagues voted for a hike.
The economic situation in the UK is not as clear as the MPC voting records make it appear. Cunliffe has several supporters who believe that the combination of supply chain concerns and the conflict in Ukraine are driving inflation higher in what he considers to be an unnatural manner.
The rise in the price of natural gas has been almost exclusively driven by the insatiable appetite of China as its economy reopens. However, the situation in China is deteriorating and that may see gas demand fall.
Cunliffe’s boss, Bank of England Governor Andrew Bailey, has gone on record as saying that it is entirely proper for the Bank to be tightening monetary policy at this time.
The Bank’s Chief Economist Huw Pill has been reserved in his comments lately, although he has been voting for rate hikes. In his latest comments, which were six weeks ago, Pill was looking to bring inflation down in a measured way, but that now appears to be an extremely outmoded view.
Yesterday, the pound remained weak versus the dollar, although traders were loath to take on fresh positions ahead of the FOMC minutes.
It traded between 1.3105 and 1.3045 and closed almost unchanged at 1.3071.
Only the war in Ukraine stopped a 50bp hike
In line with comments made by FOMC members prior to the meeting, there was genuine support for a fifty-basis point hike, but the Chairman counseled caution given the uncertainties arising from the conflict in Ukraine.
It was generally agreed that the bank’s balance sheet would be reduced by $95 billion a month and the cuts will begin at the next meeting which takes place on May 4th.
This will be a substantial reduction and will be confirmed at the next meeting.
Overall, the FOMC was concerned that inflation has broadened through the economy, and they need to bring the Fed Funds rate back to a neutral level, which was generally agreed to be around 2.4%.
The reduction of the balance sheet will amount to trillions of dollars, and each $95 billion tranche will be divided into $60 billion of treasury bonds and $35 billion of mortgage-backed securities.
There were immediate concerns voiced by observers that such swingeing cuts at the same time as rates will continue to be raised could see the economy slow to a far larger extent than the Fed intends.
The FOMC is again playing catch up, having wanted to ensure that the economy had recovered sufficiently to be able to stand such a tightening monetary policy.
The market will adopt a suck it and see view of the Fed’s actions before it responds.
Philadelphia Fed President Patrick Harker spoke before the release of the minutes and commented that inflation is far too high in the country and the risk is that it could become unmoored. Harker said he agreed with comments made recently by Fed Vice-Chairperson Lael Brainard and New York Fed President John Williams about the beginning of the reduction of the balance sheet.
Harker also voiced his concerns that unacceptably high inflation could remain an issue for some time, as petrol and food prices will remain high.
He also believes that the housing market will begin to rise as interest rates rise, and more people will return to the labour force.
The FOMC’s hawkish stance saw the dollar break above its high for the year, but it is still shy of the 100 level.
It rose to a high of 99.77 and closed at 99.64.
Ukraine conflict point to possible economic collapse
In concord with Jerome Powell, ECB President Christine Lagarde believed that rising inflation was transitory and would subside as the issues with supply chains fell away.
By now, Lagarde was expecting to be withdrawing added support for the economy and considering seeing rates rise to neutral levels as inflation fell away.
While the conflict in Ukraine has blown just about every prediction out of the water, there is a significant disagreement about how inflation can go and how low economic activity can fall.
Hiking interest rates, which is now certain to happen before the end of Q4 and possibly earlier, will add another anchor to hold the economy back, just at a time when it needs an injection of optimism.
Consumer confidence has already collapsed with current expectations at historic lows, while it is anyone’s guess just how low future expectations will fall.
There are several views among the General Council of the ECB. Lagarde clearly wants to continue to support the economy, allowing inflation to rise above 10%, while the Germans and Dutch want interest rates to be hiked at once, with rises continuing through the summer.
There is also a more neutral view that sees support continuing to be tapered while interest rates remain on hold. While this also has merit, the effect of the withdrawal of support will see Government Bond prices collapse and see the cost of borrowing soar.
Overall, Eurozone Finance Ministers agree with the opinion of Eurogroup President Pascal Donohoe that the Eurozone economy will contract this year. That has now been accepted as a fact. However, it remains to be seen how far it will fall and how long any recession will last.
The euro traded in a narrow range yesterday as traders awaited the FOMC minutes. It reached a low of 1.0874 and closed at 1.0894.
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.”