Jonathan Marriott, Chief Investment Officer
Next week, it is widely expected that the Bank of England and the US Federal Reserve (Fed) meetings will see them continue to raise interest rates. The Fed are also expected to announce the start of their Quantitative Tightening (QT) programme, as they look to unwind the measures implemented to support the economy during the pandemic.
These are not the only factors putting constraints on economic growth. With prices rising faster than wages, consumer spending is further restrained. Fiscal spending constraints and tax rises also constrain economic growth. Whilst the US and UK push ahead with tightening, the European Central Bank (ECB) is also expected to make similar moves as soon as July, but is likely to be slower than the US.
However, when we look elsewhere around the world, tightening is not universal. So far, the Bank of Japan has made no policy move despite the sharply weaker yen. Meanwhile, China’s Politburo today said they will take action to support the economy by sticking to their growth target, despite continuing pandemic-related lockdowns in the country.
This week, we have seen US growth data for the first quarter showing weaker than expected growth. However, this is unlikely to deter the Fed from its tightening path next week. It is expected that the Fed will raise rates 0.5%, not only at the next meeting, but also, at the next two meetings, make similar moves. Market expectations are for between 2.25% and 2.5% of further increases between now and the end of the year. With inflation soaring and a tight job market, this appears to be fully justified.
Causes of inflation
Inflation comes from excess demand with constrained supply. The supply side has clearly been impacted by the Ukraine war and continued restrictions in China. Fed interest rates can have little impact on these factors, it can only affect demand so, by pursuing tightening – a blunt instrument – it risks damaging the wider economy. The Fed has a dual mandate: price stability and full employment. The US employment statistics still show fairly tight conditions, but there are signs that this may be beginning to ease as people return to work post-pandemic.
As the US economy has recovered from COVID-19, job openings rose and it became difficult to recruit staff. The weekly jobless claims number was initially low, but April has seen the moving average start to move higher. Anecdotally, a friend who has a US-based leisure business noted that he was struggling to hire staff at the end of last year as the business reopened. They are now however finding it easier to bring staff on board. It may be that people who thought they could survive on savings are now finding that they cannot, given the higher prices and a lower stock market. In the 1970s, the UK witnessed an upward spiral as inflation-busting wage rises drove inflation higher. If labour market tightness eases, this is less likely. The globalisation of manufacturing and reduced power of trade unions also reduces this risk.
For inflation to remain high, the supply factors that boosted inflation this year have to repeat themselves again next year. Energy prices have been boosted by the cut-off of Russian supplies. Whilst the supply may not increase, it is unlikely that it will be cut much further. As the pandemic is affecting China for longer, as a result of its zero-tolerance policy, this should eventually ease and allow manufacturing recover. So, if energy prices flatten out and demand is weaker, we can expect inflation to moderate later this year in the US. The UK energy price cap may mean that prices go higher again in October, keeping annual inflation higher for longer in this country.
What will be the impact by the Fed’s tightening on financial markets?
In general, the markets have adjusted to the expected tightening so the Fed tightening may have little impact on the financial markets. Looking from a domestic perspective, we have seen the pound fall against the dollar from $1.35 to $1.25. However, this appears to be more of a function of the real income squeeze, which prevents a lot of further tightening by the Bank of England.
The European economy is harder hit by the Ukraine war and the euro is also down 7% against the dollar this year. Japan is not raising rates and has little in the way of natural resources (which are getting more expensive), which has resulted in 12% depreciation of the yen versus the dollar. While the US economy is more self-contained than others, this may help reduce inflationary pressures but will make US exports less competitive.
Whilst the Fed is unlikely to be deterred from its tightening path any time soon, economic pressures from a strong currency, constrained consumer spending and fiscal tightening may mean that what is priced in today is too much. If the Fed raises rates as expected, it should have little market impact. As we progress through the remainder of this year, we will look closely at the wording around Fed meetings and what they say about the path of interest rates further out.
Ten-year US Treasury yields are approaching 3% (2.84% as I write), up from 1.5% at the start of this year and even higher from the low of 0.5% seen in 2020. Despite the talking heads on TV hyperbolising the path of yields, it may yet turn out to be near the high for this cycle.
