"It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness." Charles Dickens, A Tale of Two Cities.
This week we have seen rate rises of 0.75% from both the US Federal Reserve (Fed) and the Bank of England (BoE). As they met to decide interest rates they were faced with low unemployment ("the best of times") and soaring inflation ("the worst of times"). Both were faced with imminent political events that may change government policy. In the US, we have midterm elections next Tuesday and in the UK we have a full budget on Thursday 17th November. Liz Truss’ economic policy was taken by the markets as the epitome of foolishness, so we will have to see if Jeremy Hunt and Rishi Sunak make wiser policy choices. While central banks tighten monetary conditions to fight inflation, politicians are usually more concerned about supporting economic growth. Many US politicians have been critical of the speed and extent of tightening by the Fed.
While both the UK and the US face high inflation with a shortage of labour, there are significant differences. The comments around the 0.75% rate rise reflected these differences. While the Fed is potentially slowing the pace of increases, it expects to end at a higher rate than previously envisaged. On the other hand, the Bank of England suggested that the market was pricing in too much tightening, and, while they had proceed with 0.75% this time, this would not be the new norm.
While labour is tight on both sides of the Atlantic, the drivers of inflation are somewhat different in other ways. The UK and Europe are heavily dependent on natural gas as a source of energy. The Russian sanctions have seen supplies cut and prices soar dramatically. The US is less dependent on natural gas imports and prices there have only risen moderately. The dollar has been strong and strengthened further after the Fed meeting, thus reducing the cost of imports. The pound has been weak and moved down after the BoE meeting. It is now down 17% this year, pushing import prices up. Brent crude oil has decreased from its highs but remains up 24% in dollar terms. It is up a staggering 50% in sterling terms. The Fed is more concerned about rising rents driving core inflation higher.
The transmission process for interest rate rises is also very different. In the US, most people have very long-dated thirty-year mortgages, so they are not as impacted by interest rate rises. New home sales are impacted by mortgage rate rises and this will slow activity there, however, the direct impact on consumers takes longer to feed through. In the UK, many mortgages are floating in nature and fixed rates are mostly set on a two to five year term, hence rate rises impact consumers much more rapidly. The US has a greater manufacturing sector than the UK, where investment plans will be hit by rising rates and ultimately feed through to recruitment plans. These expected cuts will eventually see the unemployment rate rise easing, thus easing wage cost pressures, but this takes time. In the UK, we are more reliant on services. During the pandemic, consumer spending was delayed and jobs in general were protected. There was some carryover spending from savings accumulated at that time, but as consumers are hit by rising energy prices and mortgage costs, services may see a sharp drop in demand. Thus, the transmission process in the UK for interest rates may be faster than in the US.
On both sides of the Atlantic, politicians will be hoping rates do not increase too excessively. The shift in Congress following the mid-term elections may make it harder for President Biden to get anything radical done in the second half of his term in office. Nevertheless, the US is a picture of political stability when compared with the UK over the last few months. The Truss-Kwarteng economic policies, which caused so much trouble for the markets, have been rapidly damped. The BoE was to some extent flying blind yesterday while we wait for Jeremy Hunt’s budget on Thursday 17th November. He issued a statement following the BoE meeting stressing the need to fight inflation and the difficult decisions that had to be made. The BoE warned of a two-year recession. It may be that this is another Chancellor who believes a recession is a price worth paying to get inflation under control, as Norman Lamont once said, ‘if we get a dose of austerity, the peak in interest rate may yet be lower and sooner than markets expect’ (read last week’s article for more on this).
In conclusion, interest rates are continuing to head higher on both sides of the Atlantic, but the speed of rate rises is likely to slow at future meetings. What is more important than the speed of rate rises is the peak rate. The Fed has said that this may be higher than previously thought and the BoE are indicating that it may be slightly lower than markets had expected. In both cases, this may be close to 5%. With the transmission process acting faster in the UK, the BoE may have reason to pause earlier in the cycle, but they may not wish to risk a further fall in the pound. It is hard to see inflation being brought under control without higher unemployment before the central banks are finished.
A return to steady growth with low unemployment is some way off. We may have yet to see "the worst of times" before we return to the "best of times".
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