MUNIX COMMENTARY – 5th August
Round and round and round we go
In the fair ground, the carousel goes round and round. So it is with central bankers, a revolving series of meetings, in the USA, then Europe, then Asia, with speeches, statements and reports informing, educating or warning politicians, the public or the press. This week it was the turn of the Monetary Policy Committee.
The decision facing the UK policy makers is much the same as in most advanced economies. Inflation is above target, largely due to the impact of the pandemic, with the distinct possibility of second round effects worsening the situation. The economy is recovering steadily but there is a considerable degree of spare capacity which can come back on stream. Debt levels are high across governments and households, with many warnings of zombie companies creating future problems for banks. The international environment is improving, as successive business surveys demonstrate, but there remain many risks, including such possibilities as new variants of the virus, geopolitical tensions in the Middle East and Asia, climatic shocks, or financial market stress. Looking into 2022, there is also a tricky transition in many countries. Fiscal largesse, sizeable cash infusions to households and businesses to cope with the pandemic, will be removed, and the size of future infrastructure and green investment programmes remains uncertain.
To no great surprise, the Monetary Policy Committee decided to stand pat at its August meeting. There is a spectrum of views across its members, but no firm evidence to sway one group behind the arguments of another. However, at the margin there were some interesting signs about future policy decisions in the next 12-18 months.
The Bank joins most other forecasters in expecting the UK economy to perform well, with GDP growing by over 7% in 2022 and then 6% in 2023 – so activity finally returns to its pre-pandemic levels by the end of this year. The Bank also admits that inflation will be well above target for some time to come. Headline inflation is expected to peak at 4% in Q4 of this year and Q1 of next year. It should then fall back – of course – to around 2½% at the end of 2022, returning to target in the second half of 2023. Yet again, the Bank warns that much of the inflation shock is transitory, reflecting such items as shortages of materials used in production. However, it is also clear that the Bank has had to reassess its views on the unemployment rate, now expected to decline to only 4¼% in 2022. A revealing phrase from Andrew Bailey’s statement was that “The Committee will be monitoring closely the incoming evidence regarding developments in the labour market, and particularly unemployment, wider measures of slack, and underlying wage pressures”. In other words, any second-round effects from higher inflation feeding through into wage awards would be a worry.
What are the monetary policy implications of this assessment? The Bank gave some clear views – if its forecasts are correct then it will need to act in the next couple of years, or more precisely “Should the economy evolve broadly in line with the central projections in the August Monetary Policy Report, some modest tightening of monetary policy over the forecast period is likely to be necessary to be consistent with meeting the inflation target sustainably in the medium term’.
What would it do? There has already seen some slowdown in the pace of QE purchases, and indeed active purchases will end in December. The MPC decided it did not want to move any more quickly on QE, and indeed was at pains to suggest that it would not take any further action on its stock of assets until the first interest rate decision. So the initial steps would be to cease in the automatic reinvestment of maturing UK government bonds, allowing the overall level of gilts to decline, as and when Bank Rate has risen to 0.5% – assuming economic circumstances are appropriate and if markets are functioning properly. Market expectations for the first interest rate move are centred on early 2023, although some view a move in late 2022 as possible.
So for the time being the MPC carousel will continue to go round and round. Into the spring of 2022, the Bank will assess whether inflation does fall back as it expects. If it does then it will
prepare the markets and economy for an interest rate move in the following 12 months, and further action on the QE programme after that. All such views are subject to change of course; as Andrew Bailey warned “The recovery will be bumpy given the nature and severity of the shock”. The net result is that UK gilt yields showed only a modest reaction to the MPC statement. 2-year yields are about 0.1%, 5-year yields about 0.25% and benchmark 10-year yields about 0.5%. After the MPC, all eyes will be on the Federal Reserve carousel for its assessment of the US economy.
Andrew Milligan is an independent economist and investment consultant. This note should be considered as general commentary on economic and financial matters and should not be considered as financial advice in any form.
Andrew Milligan an independent economist and investment consultant. From 2000-2020 he was the head of global strategy at Standard Life/Aberdeen Standard Investments, analyzing the major financial markets for global clients. He currently assists a range of organizations with reviews of their investment processes, advice on tactical investing and strategic asset allocation, and how to include ESG factors into their decision making