Pushmi-Pullyu, a rare beast indeed
The famous Dr Dolittle books and film include a peculiar animal, the Pushmi-Pullyu with two heads facing in different directions. Which way to go? Such questions are being asked by many investors. Are policy makers trying to slow down or speed up economic activity in the coming year? As one analyst described it “Central banks want to squeeze demand, but governments want to support incomes. Central banks believe a recession is largely inevitable, but the politicians are desperate to avoid one.”
Central bankers are certainly trying to dampen the business cycle. After the ECB raised interest rates by 0.75% last week, the Federal Reserve is widely expected to match or even exceed such a move at its meeting next week. Add on a much stronger US dollar, which is the world’s most important reserve currency, and a degree of quantitative tightening or bond buying affecting the Treasury market, plus mortgage rates reaching a new high of 6%, then the monetary pendulum is definitely swinging.
However, national governments see the world through rather different eyes. A massive cost of living squeeze on business and household incomes could result in a worryingly high number of insolvencies and layoffs in coming months. For example, Germany has announced another €65 billion programme of support for hard pressed households, whilst just prior to Her Majesty’s death we saw Liz Truss announce a package of £100-200 billion to cap energy bills. More details of how this will be financed will be provided by the new Chancellor to Parliament on 23rd September. In theory fiscal and monetary policy can be co-ordinated, in practice it is difficult. There is a non-voting Treasury representative sitting on the Monetary Policy Committee, so the Bank should hopefully have a good insight to the Chancellor’s thinking and announcements when it meets on September 22nd.
The details of such fiscal announcements certainly matter. On the one hand inflation should be curtailed – economists now see the peak in UK headline inflation as closer to the Bank of England’s original forecast of 13% than the frighteningly high figures of 18-22% produced by some investment banks. On the other hand a smaller rise in unemployment could mean that wage pressures become embedded. There was much discussion at the Jackson Hole central banker conference concerning a research paper from Fed economists arguing that the inexorable rise in national debt in recent decades has undermined the independence of central banks and allowed a steady uptrend in core inflation.
Economic data continues to drive inflation expectations and hence what is priced into markets for future rate decisions. The past week has seen important US inflation and UK inflation and employment reports. In the States, annual headline inflation fell to 8.3% due to lower gasoline prices but other factors were much more worrying. Medical, housing and services costs pushed the core rate up from 5.9% to 6.3%. Indeed a variety of measures suggested that underlying inflation pressures are becoming entrenched. The markets are debating whether the Fed might move by 0.75% or even 1.0% at its next Fed meeting. The terminal Fed Funds rate has been re-priced from 4.0% to at least 4.25%. Bearing in mind the shape of the inverted yield curve, so if the funds rate gets to 4.25%, it is possible that the 10 year Treasury yield would need to be about 3.75%.
In the UK the CPI report was a pleasant surprise as the headline inflation rate eased to 9.9%. Depending on the full details of the energy package from the government, the headline rate might peak not far above current levels. At face value the report that UK unemployment fell to a new low of 3.6% would worry the MPC but this largely reflected more people leaving the workforce, partly due to illness, whilst wages adjusted for inflation are down 3.8% from a year ago. On other measures, the number of people not in employment has reached a new high of over 5 million whilst the number of vacancies had the biggest decline since the pandemic. Together with the news that GDP is flat lining quarter on quarter, so the market view has consolidated that the Bank will likely raise rates by 0.5% next week although hawkish observers see 0.75% as more likely.
European policy makers also seem to be taking global inflationary pressures into account and worry more about the effect of governments easing fiscal policy. French policymaker Francois Villeroy de Galhau said the ECB could reach neutral rates by the end of the year. This encouraged a further move higher in the terminal rate towards 2.75% for EMU members.
The autumn looks to see an interesting debate in the bond market about how much attention to pay to fiscal policy, but at present the Pull Me of central banks seems to be more influential than the Push You of finance ministers.
Bond yields at the time of writing this week
% 2 year 5 year 10 year
USA 3.84 3.64 3.44
UK 3.08 3.093 3.15
Germany 1.49 1.60 1.71
Andrew Milligan is an independent economist and investment consultant. This note is offered 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