9 January 2024: Rebound in energy prices may delay rate cuts

There is a growing feeling that inflation may be close to the lowest level that is achievable given current monetary policy. The rate hikes that have taken place can only reduce demand to a finite degree before they drive the economy into recession.

The Bank of England is acutely aware that the economy will also be relying on a “global effect” from energy and food prices to bring price increases back close to the Government’s 2% target.

While the fall in inflation over the past few months has been encouraging for those who want rate cuts to begin sooner rather than later, just as rate the final one or two hikes were critical in the fight against inflation, so the timing of cuts is just as vital. Too soon and inflation may reignite, too late and the economy will fall into a more prolonged recession.

Former MPC member DeAnne Julius, who was a member of the rate-setting committee in calmer times, voted to maintain rates at more than half of her forty-five meetings, spoke yesterday of her opinion that the Bank of England may not be in a position to cut rates at all this year given the possibility of a fresh energy shock in response to any escalation of the conflicts in Ukraine and Gaza.

The tensions that exist, particularly in Gaza, make a fresh energy shock a significant possibility. If that were to happen, it would leave the Bank of England’s plans in tatters and have a major effect on the Government’s ability to lower taxes both pre- and post-election as they have promised recently.

The Government is becoming embroiled in yet another situation that they had hoped would simply go away. The scandal over faulty accounting software that led to several hundred post office managers being accused of fraud and theft should have been dealt with sooner, and now is threatening to damage Rishi Sunak’s image even more.

Mortgage rates and other borrowing costs have been coming down recently in anticipation of an imminent loosening of monetary policy, but that optimism is beginning to fade as the Opposition accuses the Government of more empty promises designed to fool the electorate.

The election race is now in full swing, with every comment from either side of Parliament being viewed through a lens of its effect on voter confidence and both sides desperately trying to manage the optics of every fresh piece of news.

The pound is currently trending higher, having had four consecutive higher daily closes. Yesterday, it reached a high of 1.2767 and closed at 1.2752. While it is still in its current range, traders will expect to see an increase in daily volatility, but as it challenges the outer ranges of that range it may well “run out of steam.”

unseen divisions are growing in the view of the outlook for the U.S. economy. Economists and commentators are being encouraged by the Administration to agree that a soft landing for the economy has been delivered by Fed policy over the past six months or so.

The December employment report couldn’t have been better for the FOMC had they designed it. It made it clear that interest rates have been raised to a level that restricts demand, but not by an amount that has driven the economy towards recession.

The Fed is working towards a series of rate cuts this year that should bring the Fed Funds rate down to around four percent by the year-end.

Naturally, the longer they leave agreeing to the first cut means that the space between cuts will be less and may promote the idea that the Central Bank is concerned about a loss of momentum.

In the middle of last year, several commentators were clinging to the idea that there were two “missing pieces to the jigsaw” regarding a soft landing. It had been assumed that the FOMC paused, and then officially ended its cycle of rate hikes in response to those.

The first was the continued fall in the Index of Leading Indicators, while the continued inversion of the yield curve had preceded a recession every time it had happened since the Second World War.

Those two factors still exist and those who feel that a soft landing may be fleeting at best, believe that there is no time limit on when the recession could take place.

The rate hikes that ended last year were designed to slow the economy and third quarter GDP, which was confirmed at 4.9%, showed that despite the hikes the economy was in a solid recovery.

It is unlikely that the fourth quarter will supply such strong numbers, as has been shown by preliminary output figures released so far.

The Fed doesn’t publish its view of what will be an optimum level for growth in the most recent, and coming quarters, since its mandate only covers employment and inflation, both of which are at an optimum level currently.

The dollar index has recovered from its pre-Christmas “wobble” but hasn’t exhibited any real strength yet, as the market still considers which G7 Central Bank will be the first to cut rates.

Yesterday, the index acted similarly to other major currencies, driven by commercial flows, but remaining in a relatively narrow range as traders digested the finer points of the December employment report. It fell to a low of 102.07 but recovered to close at 107.28.

At the next meeting of the Governing Council of the ECB, it has already been agreed that a “watching brief” will continue, with no decision on interest rate cuts being discussed until the April meeting.

The economy is looking like it may be beginning to see a few “green shoots” of a recovery, but it is extremely early in the cycle for those to be able to flourish, particularly with interest rates at their current level.

In their customary conservative manner, some members of the Governing Council are expressing concern about the loss of momentum in the pace of the fall in inflation, particularly core inflation.

Christine Lagarde has said recently that she is satisfied if inflation is falling, as the core fell from 3.6% to 3.4% last month. Some believe that with rates at their most restrictive, inflation should be seeing a more significant fall.

It was expected that headline inflation, which includes volatile items like energy, alcohol, and tobacco, would be less affected by restrictive interest rates and this was proven to be correct in December as the headline rate rose to 2.9% from 2.4% the previous month.

In fairness, there were no undue celebrations about the proximity of headline inflation to the ECB’s target rate in November, just as there were no particular concerns raised about its rise in December.

Although the core level fell by just 0.2% it recorded its lowest level in twenty-one months which merited a muted celebration even to the most “hard-hearted” hawk.

The ECB has made it clear that it will keep rates at an elevated level until inflation has been defeated. While that is an admirable decision, there is a mounting concern that although rates are at a restrictive level, they may not be so restrictive in a region that is so diverse, to bring inflation to 2% in every Eurozone economy.

That conversation is slated to take place in April, and until then the Euro will likely glean a degree of support.

Yesterday, the single currency rallied, also within its recent range, to a high of 1.0978 and closed at 1.0954. It appears that the 1.10 level no longer holds any fears for those who are bullish, and resistance is now positioned around the 1.1050 area.

Have a great day!