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Impact of inflation and the Fed rate rise

16 June 2017

What impact does the rise in inflation have?

This month consumer prices were reported to be up 2.9% over the past year. This is a steeper rise than the Bank of England expected in its most recent quarterly inflation report that had the Consumer Price Index peaking at 2.8% later in the year. On Thursday, three members of the Bank of England Monetary Policy Committee (“MPC”) voted to raise rates with five members against reflecting concerns over the rise in inflation. While the probability of a rate rise this year has moved higher, we believe, on balance, the MPC will err on the side of caution and not raise rates. The rise in inflation is mostly a delayed reaction to the fall in sterling after the Brexit referendum and the recovery in oil prices at the start of 2016. While the effect of the devaluation of the pound may have further to go, in the short-term we expect these one off influences to fade next year and the rate of inflation to fall back to the 2% MPC target or lower. The uncertainty around the path of Brexit negotiations has only increased with the election which will give the MPC more reason for concern.

Inflation is now rising faster than wages which were reported to be up 2.1% in the last year despite a relatively low level of unemployment at 4.6%. The Retail Price Index, which includes a higher proportion of housing costs, rose 3.7% and shows an even bigger squeeze in real wages. When living costs rise more than wages, spending on necessities rises, leaving less for other items which acts as a further constraint on economic growth. One indication that this is beginning to bite came from Visa who reported that spending on their cards had slowed; this was also reflected in weaker retail sales data this month. This situation is likely to remain poor for the rest of this year and may be one thing that influenced Theresa May when she was deciding the timing of the election. If there is a second election this year the economic picture may be less favourable.

Officially the MPC only have a target for inflation but in practice they have sighted the impact on employment and the wider economy as reasons not to raise rates when inflation is above target. We feel that that is reason enough to hold back on rate rises.

The Federal Reserve raised interest rates this week, what impact does that have?

The Federal Reserve (“Fed”) raised interest rates for the second time this year and they expect one more rate rise this year. This was very widely expected and had little impact on markets. Indeed, the committee’s median expectation for future interest rates remained unchanged from the previous meeting, despite inflation falling further below expectations this month. The Fed is looking to very gradually remove the support it put in place following the financial crisis, while not impacting asset prices. So far it has raised rates four times in the last two years, without a major reverse in equity markets so can be deemed a success. The next stage will be to reduce the size of its balance sheet. Yellen said that once this process was in place she wanted it to be as dull as watching paint dry. If she is as successful at managing expectations on reducing the balance sheet as she has been with interest rates we will have little to worry about.

As for the next interest rate rise, we believe that the Fed will do another rate rise towards the end of this year. At present, the futures market price this at slightly less than a 50% chance. Providing inflation does not dip further we should expect the Fed to gently manage up expectations for December. Looking at the longer term, we expect the balance sheet reduction and rises in interest rates to be very gradual and assume that this will have little impact on equity markets. If and when Trump makes progress on tax cuts, deregulation and infrastructure spending proposals, there is likely to be more of an impact on markets than the Fed interest rate policy.


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