The heat is coming off the Bank, but rising heat complicates the task facing all central banks
The Bank of England has turned up the heat at recent MPC meetings, making it abundantly clear that it will tighten monetary policy aggressively if needed to restrain inflation. There was good news then from the UK’s latest CPI report, which made a small move of 0.25% more likely than a larger hike of 0.5% at the August MPC meeting. However, all central banks will be looking carefully at the thermometer in coming weeks, whilst the heat is rising on governments in Russia and China.
In the UK, the inflation report for June was better than the markets had expected. Headline inflation fell to 7.9% a year, and core inflation excluding food and energy declined to 6.9%. Lower energy prices helped a lot, although food price inflation above 17% a year shows the pressures on household finances. Away from the headline, there are continued problems with service sector inflation continuing to grow above 6% year on year. All in all, the deceleration in UK inflation remains rather moderate compared with other countries. As one expert put it “the UK is thus merely 26% into its disinflation journey (from peak to target); the US is 86% there”.
Generally good news, then, but the MPC will want to see much more helpful developments in relation to wages and salaries before it feels it can give as positive signals as the Fed and ECB. There are some helpful signs that previous monetary tightening is starting to have an effect. The number of profit warnings issued by UK listed companies has risen for seven consecutive quarters, with firms warning about economic uncertainty, falling sales, and changing credit conditions. Household spending is being affected by a decline in household wealth worth over £2 trillion. The probability of a recession in the next 12 months is put at 60% in a survey by economists for Bloomberg, and such economists only expect GDP growth of 1% at best in 2023 and 2024. As the heat builds on the UK government though to ‘do something’ in the run up to the next General Election in 2024, the Bank will keep a watchful eye on any announcements about fiscal easing which could complicate its efforts to restrain activity and inflation.
The financial markets expect that the peak of US and European interest rates will soon be seen. Such a view was enhanced by a speech from Dutch ECB hawk Klaas Knot, indicating that the ECB might pause after raising rates again later in July. This was backed up by further economic data suggesting that Eurozone economic activity remains rather muted. Car sales fell about 12% in the second quarter, helping explain why industrial production has declined over 5% on an annualised basis. Forecasts for GDP growth in Germany are easing towards zero this year and only 1% for next. The French INSEE business confidence survey for July does not suggest any acceleration in growth in that economy. Nevertheless, ECB hawks will continue to point to core inflation still growing 5.5% pa into June, and want to see this decelerate noticeably into year end before they could countenance any relaxation of policy.
Investors have become rather more certain that the US economy can escape recession this year and next. The latest economic data suggests that activity is expanding about 2.0-2.5% a year into the summer. Manufacturing is clearly in recession, and the housing sector under pressure from 7% mortgage rates, but consumer spending is holding up. At first sight, retail sales only expanding by 1.5% in the year to June might seem rather low, but much of this reflects lower gasoline prices and the underlying strength of consumer spending between Q1 and Q2 looks solid enough. All this helps explain why US bond yields backed up a little over the past week.
Central bankers, investors and economists all expect headline inflation to continue to decelerate in the major economies into year end. The risk should not be ignored of adverse surprises in coming months. Climate shocks are becoming more common, whilst pressure is growing on governments in Russia and China. July looks on course to be the hottest month globally since records began. Harvests are being severely affected by the heat bubbles across the USA, Europe and China. Combined with Russia’s ban on further wheat exports by sea from Ukraine, an index of agricultural prices jumped to its highest since June last year. The latest Chinese data also indicated a weaker than expected economy. Youth unemployment reaching 20% will put the heat onto President XI, who might respond with a major stimulus package. Potentially all this could complicate the task facing the major central banks – just as they hoped for a cooler time ahead.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 4.85 4.12 3.88
UK 5.03 4.40 4.32
Germany 3.26 2.61 2.47
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