Weekly update - Topography and central banks

The European Central Bank (“ECB”) raised interest rates last week by 25 basis points and was pretty clear that they do not expect to have to tighten them any further. The key quote from their statement was ‘Based on its current assessment the Governing Council considers that the key ECB interest rates have reached levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to target’1. This will, of course, be data dependent but inflation does appear to be easing, economic activity in the Eurozone is weakening and business confidence waning; crucially though, the ECB’s economists are not forecasting that the Eurozone will tip into recession.

Eyes this week will turn to the Bank of England (“BoE”) which is in a similar position, although there is perhaps more disagreement amongst committee members. The BoE has raised interest rates at the last 14 consecutive meetings and, on balance, markets are still expecting that to become 15 this week. However, mixed data in the UK is also increasing the chances that rates are nearing their peak.

Figures released in the last week highlight the dilemma. On the one hand, we had the release of the average earnings numbers, which showed that total earnings rose 8.5% in the three months to July when compared to the same three months last year2. Part of the reason for the jump was one-off payments made to resolve pay disputes with civil servants and some NHS staff, but record wage growth will concern the MPC. The other side of the coin showed in the rest of the labour data which was less resilience. Unemployment edged up and employment fell. The weaker tone to economic data was also reflected this week with official GDP numbers which reported that the UK Economy as a whole contracted by 0.5% in July. This number is very provisional and the ONS reported that strike action and bad weather had had an impact3.

This data will strengthen the conviction of some MPC members who think that, like the ECB, their work is almost done.

Recent comments from Governor Bailey, that monetary policy is ‘much nearer now to the top of the cycle’ coupled with additional comments from Jon Cunliffe and Swati Dhingra show that a significant faction of the committee thinks the peak in interest rates for this cycle is near. However, this view is not universally held. MPC member Catherine Mann is concerned that if inflation is not squeezed out now then there will have to be a worse trade-off in the future.

If we accept that it is more likely than not that we are nearing the peak in interest rates, then attention starts to turn to what happens next. At the start of this interest rate tightening cycle, central bankers labelled increasing inflation as ‘transitory’ and the feeling was that interest rates would rise; inflation would fall and so interest rates would return to the ultra-low levels people had become accustomed to. However, things have not turned out quite as anticipated and in a recent speech the Bank of England Chief Economist Hugh Pill suggested a different path. In his speech, he likened the original expectations of a sharp increase in interest rates followed by an equally sharp decrease to a profile which looked like the Matterhorn. However, with inflation having stayed far higher for longer and looking increasingly ingrained in some sectors of the economy, he suggested that interest rates could peak at a slightly lower level than markets are expecting but then stay higher for longer. To complete the geographic analogy, he likened this profile to Table Mountain (it helped that he was giving the speech in Cape Town). There is support for this view from other central banks; the quote from the ECB, which we used at the start of this note, references Eurozone rates staying at current levels for a ‘sufficiently long duration’.

Markets are following this debate with interest (excuse the pun). For example, Sterling one-year yields have fallen from 6.50% to 6.00%1 over the last month or so but the yield curve out to one year remains positive, suggesting a lower peak for interest rates but no real expectation of a cut.

On balance, we expect another UK rate rise this week, although the vote might be closer than some think. That said, we have a lot of sympathy for the ‘higher for longer’ argument. It is likely that, if UK interest rates continue to rise, real damage could be done to the economy. If conditions allow then interest rates could perhaps moderate a little over the next year. However structural change and geopolitical uncertainty suggest that higher inflation and increased volatility could be here to stay. This suggests that interest rates may need to remain at higher levels, although many would argue that this is just re-adjusting to a more normal historical pattern.

Have a good week everyone.

Sources:

  • 1 Bloomberg
  • 2 The Guardian
  • 3 BBC
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