Munix Weekly 5th August
Can we put the inflation genie back in the bottle? Let’s be honest…..
During the course of 2022, central banks have become more aggressive in their interest rate decisions, as they fear that they took their eye of the ball and allowed inflation to become entrenched. The US has raised interest rates by 0.75% on two successive occasions, meaning the policy tightening experienced so far in 2022 has been the most extreme for 40 years. The ECB and MPC are not quite as forceful, but both are moving towards moving rates in 0.5% rather than 0.25% steps as they seek to dampen inflation expectations.
This week’s announcement from the MPC to raise rates by 0.5% to 1.75% surprised few people. Andrew Bailey, the Governor, had already strongly hinted that such a move was the focus of the meeting’s discussion. Like all central banks, however, it faces a difficult balancing act about how aggressive to be in the rest of the year. After all, a few days ago the National Institute of Economic and Social Research warned that the economy is already in recession as the cost of living crisis has devastated household incomes. Real disposable incomes will fall 2.5% this year and remain 7% below their pre-COVID level through 2026. The MPC also made a rather honest appraisal of the difficult path facing the UK economy. It downgraded its growth forecasts, suggesting that the UK will experience negative year-on-year growth lasting into 2024. Hence, the Bank of England became the first major advanced economy central bank to project explicitly a recession, with a peak to trough fall in output of 2%. The effect is seen most noticeably in its forecast of the unemployment rate, expected to rise steadily from 3.8% now to 6.3% in autumn 2023.
On the one hand, inflation pressures are abundantly clear. Further pressure on Russian gas supplies and the mounting global food crisis are feeding through the inflation chain. It was little surprise that the Bank forecasts that headline CPI inflation could reach over 13% a year in October; after all some economists are warning the peak could be as high as 15% – and that assumes Russia does not dial down its gas exports even further. Hence, any interest rate moves by the MPC stand alongside the unpleasant fact that the energy shock hitting household incomes is about five times as bad as the worst episode of the 1970s – unless the incoming Prime Minister does bring about a scene changing shift in fiscal policy.
It would be a mistake only to pay attention to growth, inflation and interest rate views from the Bank. There are other weapons in its armoury. The Bank also announced that it aims in September to start the first active debt sales by any major central bank, totalling about £10 billion a quarter. Over time this should mean private sector demand for gilts will become more important. At what price will bonds be seen as attractive investments?
The net result is that financial markets still consider that UK interest rates will rise again – indeed there is speculation of another 0.5% move by the MPC in September – but not too aggressively. In June, the forward yield curve showed the Bank’s base rate was expected to peak at 3.6% in July next year. This week, markets are expecting rates to peak around 2.75-3.0% next summer, a significant downwards revision.
The slowdown in the UK mirrors the deceleration in economic activity seen across most of the major economies, as reported in the important monthly ISM/PMI business surveys. China’s figure slipped below 50, whilst the USA, UK and EU generally eased towards 50-53. Although 45-50 levels are generally seen as indicating recession in most countries, there were worrying details in the surveys concerning weak order books and rising inventories which all suggest further weakness ahead. This chimed with other evidence of slacker demand for new workers. In the USA, the Job Openings and Labour Turnover Survey showed the number of available positions decreased from 11.3 million to 10.7m. In the UK, the Recruitment & Employment Confederation’s measure of confidence in hiring and investment fell to its lowest since the second quarter of 2020.
It is all well and good for markets to look at such data and assume that central banks will rapidly and aggressively move from tightening to easing mode within the coming year. However, this was not the conclusion which a number of Federal Reserve Governors wished the market to draw. Inflation targets and overshooting matter for central bank officials. This week saw a series of statements which alarmed the markets. Mary Daly said she was “puzzled” by bond market prices that suggest the central bank will shift to rate cuts in the first half of next year. The Fed is “nowhere near” almost done and is still “a long way to go” to lower inflation. Loretta Mester said inflation has yet to peak so the Fed should raise interest rates above 4% to do so; she would need to see several months of very compelling evidence that inflation is on a sustainable path down to 2% for policymakers to ease off. Charles Evans said that unless inflation abates significantly before the next meeting, he would back a move of 0.5% or even 0.75% in September.
Bonds are meant to be steady investments which can be held safely in portfolios. This may be true in the long-term but not in the short. During the past week, 2 year US Treasury yields rose and fell by about 0.2% in a single day, some of the biggest moves since mid-June. Such volatility adds to the complexity in trying to understand what bond investors actually expect to see in coming months. The net result, however, remains an inverted yield curve in the USA, a much flatter one in the UK, and a less steep German curve than even a month ago. Who will be correct about the future path of inflation, worried central bank officials or less concerned bond investors? Will other central banks be as honest as the MPC in their appraisal of the economic risks? Time will tell.
Bond yields at the time of writing this week
% 2 year 5 year 10 year
USA 3.07 2.81 2.70
UK 1.83 1.74 1.91
Germany 0.32 0.54 0.80
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