All eyes were on the UK
After weeks focused on the USA and EU, attention turned to some small islands off the coast of Europe, initially for the Coronation and then for decisions by the Bank of England. In the event, there were few surprises in either case, an outpouring of support for the new King, and another rate rise in the UK.
The MPC increased the base rate from 4.25% to 4.5%, its 12th consecutive move taking rates to their highest level since 2008. The 7-2 vote was quite understandable; as many commentators acknowledged, the Bank is being forced to follow in the footsteps of monetary tightening by the Federal Reserve and ECB. Inflationary pressures remain higher in the UK than elsewhere; although the Bank forecasts headline CPI to decline it is still expected to be 5% by year end, and core inflation sticky into 2024. Newspapers may trumpet the UK avoiding recession; households, businesses and the government will be concerned that the Bank also forecasts that UK economic growth will not exceed 1% a year until 2026. The UK remains stuck in a low productivity trap. On balance, the market waxes and wanes between one and two more 0.25% MPC moves.
The Bank also faces the backdrop that the ECB is likely to move twice more this year. ECB chief economist Philip Lane acknowledged that “There’s a lot of disinflation coming later this year”. However, whilst the ECB expects inflation to slow below 3% by year end, it also forecasts that it could take almost 2 years to fall back to the 2% target. Surveys signal sticky inflation expectations amongst consumers. European business surveys continue to follow the path seen in most countries, whereby strong service sector activity more than compensates for weak manufacturing growth.
It is quite likely that the Federal Reserve will pause its monetary tightening in June – but that reflects conditions in the credit markets, and Congressional politics, rather than the economic data. Admittedly, the headline CPI rate eased again to 4.9%, its lowest since April 2021. It is the case that durable goods inflation is declining fast, and energy prices are well below levels of a year ago. Yet tight labour markets continue to support service sector and hence core inflation. Employment rose steadily in April, pushing the unemployment rate down to a new low of 3.4% and supporting wages growing well above 4% from a year ago. There are recessionary risks but the Atlanta Fed’s model to estimate economic growth in Q2 is tracking a robust rate of 2.7%.
Evidence is growing of a slowly tightening environment for consumer and especially business credit. US banks are compressing lending standards, for some out of concern for the economic outlook, and future bad debts, for others worries about liquidity, whether deposits will flee too quickly. Small companies seem most at risk from a lack of credit access, although the latest small business survey reported limited problems so far.
The Fed is watching carefully, of course. However, its semi-annual report on financial stability said the banking sector overall appears well positioned to weather recent industry turmoil. Treasury Secretary Yellen also made reassuring noises that the US banking system has adequate capital and liquidity and that regulators are prepared to step in if current pressures led to a major contagion.
Bond markets are paying rather more attention to the possibility of a mid-summer political rather than a banking crisis, as neither the Republicans nor Democrats are yet ready to give way on the thorny issue of raising the debt ceiling. A new report from the White House’s Council of Economic Advisers outlining the potential economic shock impact fell on deaf ears among Republicans. A majority of Republican senators are standing firm with their House of Representative counterparts that they will not come to President Biden’s rescue.
One scenario is that both sides buy time with a short-lived extension. If crisis is averted, then bond markets may need to reassess the widely held view that recessionary pressures will force the Fed to cut rates before year end. New York Fed President John Williams was the latest in a long line of central bankers to warn that it was too soon to say whether the central bank is done with tightening monetary policy: “In my forecast I see a need to keep a restrictive stance of policy in place for quite some time to make sure we really bring inflation down from 4% all the way to 2%. I do not see in my baseline forecast any reason to cut interest rates this year”.
Looking into the summer, therefore, a divide is growing across both sides of the Atlantic. Europe and the UK see the need for further monetary tightening until core inflation is firmly on a downward path. The USA looks to be on pause, but it may require much more pain in terms of a banking crisis or a political crisis to force the Federal Reserve away from its stance that it would prefer to remain on hold for some time. It is understandable against such a complicated economic, banking and political backdrop that technical measures of short-term interest rates volatility remain the most elevated since 2008.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 3.88 3.33 3.38
UK 3.760 3.561 3.74
Germany 2.592 2.17 2.28
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