MUNIX COMMENTARY – 21st October
Singing from the same hymn sheet
Central bankers and financial markets have a complex relationship. On some occasions policy makers lead the way, giving a strong steer to investors that, if a certain event happens, they will respond accordingly. On other occasions, the bond market makes up its mind that the economy is set on a certain course, concluding that policy can only go in one direction despite any central bank protestations to the contrary. Around this orbit the economics profession and financial journalists interpreting the comments and views of both groups. The UK faces an interesting conundrum at present; are the MPC, the money markets, economists and journalists all singing from the same hymn sheet?
Andrew Bailey and several colleagues at the Bank have given strong hints that interest rates must rise, possibly as soon as November this year. After all, the main task of the Bank of England is to keep inflation on target over its two-year horizon. The economic backdrop is not favourable. There have been two successive months with inflation above 3% a year, whilst the worst effects of the surge in gas and petrol prices will inexorably appear over the winter. The Bank has repeatedly warned about the risks from the labour market, if wage increases broaden out and inflation expectations deteriorate. Both market and household survey measures of UK inflation expectations have been rising, an obvious worry for more hawkish members of the MPC. The money markets have followed such thinking to its logical conclusion and are moving towards pricing in interest rates reaching 0.25% at the end of this year with a similar increase by the middle of next.
It must be noted that economists are less sure about such an outcome. A recent survey reported the consensus expects the first rate increase next May with a second in November 2022 – although it must be admitted there is a broad range of views across the profession. Hence, some newspaper stories have begun to appear warning that the Bank might be making a serious error from tightening too soon.
One reason for the divergence between money market and economist expectations would be greater or lesser emphasis on weaker economic growth data rather than stronger inflation figures. The UK, and indeed most of the major economies, appear to be slowing into the second half of the year. Not only is growth decelerating in China but the authorities are finding it difficult to turn around the energy crisis and problems in the property sector. Recent weak industrial production data in the USA have caused some estimates of Q3 GDP growth to come down to just 1%. Although various factors such as covid and poor weather partially explain such downgrades, it is becoming more apparent by the day that many of the shortages of labour and key components will be long lasting. A recent survey of chief financial officers of the UK’s largest companies warned that disruptions facing British businesses are likely to persist until late 2022 or even 2023. Nor will governments come to the rescue; the forthcoming UK Budget will see some tax increases, whilst across the Atlantic, Congress is finding it very difficult to agree the much-promised mega infrastructure package. Fiscal restraint is becoming the order of the day.
Central bankers have had an easy job for several years – cut rates and carry out QE to support the economy. Now they face a very different state of affairs. The annual rate of G7 consumer price inflation almost reached 4% in August, the highest level seen since September 2008. If the MPC raise interest rates in November, economists and financial commentators may switch towards a rather more aggressive view of what needs to be done in 2022 to curb a worrying degree of pipeline inflation. Conversely if the Bank does not act in November, the money markets might re-consider the state of affairs resulting in a rather different outlook priced into the bond markets. Can central bankers create some harmony across the various groups, or will we hear discordant tones in coming weeks?
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