8 September 2022: Putin, not BoE, driving recession

Putin, not BoE, driving recession

8th September: Highlights

  • A break of 1.1410 could drive drop to all-time low
  • Mester doesn’t believe inflation has peaked
  • Worsening crisis could bring fall to 0.9500

GBP – Bailey testifies before House Select Committee

Bank of England Governor Andrew Bailey, making his quarterly report to MPs yesterday, said that there is nothing that the Central Bank can do to avoid the country slipping into recession in the fourth quarter of this year and not seeing any growth in 2023.

He claimed that it is not the Bank of England’s monetary policy decisions that have created the crisis, but Russian President Vladimir Putin’s invasion of Ukraine which has driven up the price of basic foodstuffs together with his actions over energy supply.

While the UK isn’t dependent on Russian gas to the same extent as, say, Germany, the economy is still energy dependent.

The new Prime Minister, Liz Truss, will today flesh out the Government’s plans to deal with the rising cost of energy. It is expected that the energy cap will be frozen and around £2,500 for the next eighteen months for domestic suppliers.

Little has been said about businesses, whose energy bills have risen by a multiple of three or even four over the past year.

In a report from the Federation of Small Businesses published yesterday, it was estimated that fifty-three thousand firms are in danger of failing due to rising energy bills. The Prime Minister, during Prime Minister’s questions in Parliament yesterday, confirmed that hope would be provided for both domestic and commercial consumers.

Several of Bailey’s colleagues on the Monetary Policy Committee made speeches yesterday on the themes of the economy and monetary policy.

Catherine Mann spoke of her fear that what were believed to be short term spikes in inflation are becoming embedded in domestic inflation, while Silvana Tenreyro believes that most of the effect of the recent tightening of monetary policy has already been seen

The Bank’s Chief Economist Hugh Pill also spoke yesterday. He believes that it is important to create a balance between interest rate rises and the effect of quantitative tightening. The so-called printing of money or its opposite was frowned upon when it was first introduced, but now it is seen as a genuine policy tool.

Sterling fell to a twenty-plus year low versus the dollar. It reached a low of 1.1405 but performed a strong recovery as traders realized it had come too far too fast. It eventually closed at 1.1525, marginally higher on the day.

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USD – Mester believes that wages driving inflation in part

Loretta Mester, the most outspoken hawk on the FOMC, spoke yesterday of her doubt that inflation has yet peaked. This, she asserted, is why she believes that short term interest rates will rise to 4% or even higher and remain elevated for the whole of 2023.

Higher wages are becoming embedded in domestic inflation, and the goal of the Central Bank is to engineer a slowdown without driving the economy into recession. That is the so-called soft landing, which economists believe is becoming less and less possible.

There is a discussion to be had regarding the size of the hike at the September meeting, and it is futile to have any preconception given the fast-moving nature of the economy.

She believes that it is better to focus on the path of interest rates rather than one individual meeting. That has been a constant theme for Central Bankers who strive to smooth out volatility, but they are making monetary policy decisions it is almost impossible to do.

Lael Brainard, the Central Bank’s Vice Chair, likened changing the course of inflation to trying to stop and change the course of a supertanker. Policy decisions are made with a view to their effect being fully appreciated some weeks or even months down the line.

Inflation is a blight that affects lower income homes proportionally higher than the middle class and the Fed is trying through changes in policy to lessen that effect, although they have negligible effect on fiscal policy which is the Treasury’s domain.

She agreed with Bank of England Governor, Andrew Bailey, that the Russian invasion of Ukraine has created a series of price shocks hitting goods, labour, and commodities.

The country’s trade deficit shrunk to a nine-month low according to data released yesterday. It fell to a low of 70.6 billion, a fall of 12.6% over the previous month. This is in no small part to the strength of the dollar, which makes imports cheaper. While the effect is minimal, this is another move for GDP and movies the economy a little further from falling into recession.

Thomas Barkin, the President of the Richmond Federal Reserve, continued the theme of maintaining pressure on inflation yesterday. He believes that having come so far, and risked so much, the Fed must keep its foot on the brake, even if it is with a lighter touch than has been seen recently, to ensure that inflation is brought back under control.

The dollar index continued to rally yesterday. It climbed to a high of 110.7 but ran into a bout of profit taking later in the day and closed lower at 109.56.

EUR – ECB in a real fix

It has been said before and, no doubt, this won’t be the last time it’s repeated, but the meeting of the ECB’s Governing Council is one of the most important ever.

The Central Bank will hike interest rates either by fifty or seventy-five basis points to gain a degree of control which is close to five times the Central Bank’s target.

There is a school of thought that believes that even if they hike by seventy-five points, it will not be sufficient. That is true, but Christine Lagarde must consider all sides of the argument and were they to tighten, by say, one hundred points, the shock that it would cause to the weaker heavily indebted economies of the eurozone would definitely tip them into recession.

A recession is almost inevitable, but the Bank would like to avoid being accused of precipitating it.

The goal of the ECB is to raise rates sufficiently to stifle rampant inflation without provoking a second sovereign bond crisis in a decade.

It may be that if debt crisis 2.0 does happen, it would sound the death knell for the entire Eurozone experiment, in that it would prove that fighting inflation, or at least keeping a lid on it is neither possible nor desirable for several members.

Hedge funds have placed the largest bet against Italian bonds since 2008 believing a crisis is almost unavoidable.

A hike of seventy-five basis points has been labelled a mega hike, although Christine Lagarde appears to have become less convinced over the past few days. It is doubtful that she believes it is not necessary, but that it may cause more harm than good across the Eurozone as a whole.

It will all become a little clearer at lunchtime today, although we will have to await the publication of the minutes to find out who said what. Lagarde will be left to support the decision at her press conference, and she must guard against showing that there is anything other than unity amongst the Community’s Central Bankers.

The Euro rose strongly yesterday, on profit taking on weak short positions. It reached a high of 1.0001 and closed at that level.

Have a great day!

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.