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“With the lights out, its less dangerous”

Nirvana, Smells Like Teen Spirit

Last week, we discussed the latest Federal Open Market Committee (FOMC) and the evolution of US monetary policy. We argued that the move towards data dependence as a function of achieving its near-term goal - “moving expeditiously to neutral” - represented a watershed. An acknowledgement that the “expeditious” policy normalisation has had an effect on demand (and will continue to do so as previous rate rises work their way through the system), and a more balanced view of the risks to monetary policy, notably reduce the risk of significantly higher rates. More broadly this has very clear implications for the USD and for US (and wider) bond markets as tail risks are abridged or curtailed - weaker and stronger respectively at the margin.

However, despite what we would consider to be a positive progression from this ‘watershed’ moment in the US monetary policy evolution, the domestic focus, at least from the mainstream media has been whether or not the US is currently in a recession or not - mostly by reference to the narrow definition of two quarters of negative growth. Federal Reserve System (Fed) speakers have been unanimous in their narrative that the labour market strength is such that it is inconsistent with this recessionary narrative (indeed it is also likely that the Q2 GDP data is revised upwards, thus making the debate moot anyway). Furthermore, in the US there is also a clear consensus among policymakers that there is a clear path to a soft landing in the US - i.e., a path to below equilibrium but importantly still positive growth going forward.

After today’s Bank of England meeting, it is clear that the consensus on the UK’s Monetary Policy Committee is that there will be a substantial and prolonged period of negative growth in the UK. No debate, no punches, just a clear message. Recession is coming.

The Bank raised rates 50bps in its August policy meeting (a historic event - the largest rate hike in the history of the independent Bank of England) as it continues to battle with stubbornly high inflation - revised higher again in the MPR to now show a peak of 13.3% in October as the energy price cap rise feeds directly into the headline. There was broad agreement on the MPC that domestic price pressures are elevated, and the labour market remains tight. Interestingly, however, it is very clear that the core driver of inflation is singular in nature - gas prices. Thus, despite the elevated energy assumptions of the MPR forecasting, the demand destruction from a prolonged real income squeeze pushes inflation at the forecast horizon to just 0.76%.

Furthermore, the BoE also laid out their plan for ‘active’ asset sales, or ‘active’ QT, whereby the Bank will not just be allowing the roll-off of expiring assets held in the QE asset stock, but also they are ‘minded’ (will commence if market conditions enable) to begin selling gilt holdings in the order of £10B per quarter in the first year.

We have a couple of thoughts:

Firstly, the Bank of England’s baseline projections are calculated using only ‘announced’ fiscal policy actions. Thus, the very strong likelihood that the new leader of the Conservative Party (and thus PM) will offer substantial and immediate fiscal easing is not factored into the growth projections. Indeed, the current bookies favourite, Secretary of State for Foreign, Commonwealth and Development Affairs of the UK has proposed around a GBP 30B fiscal boost through tax cuts. Ironically, if you were about to be crowned Prime Minister of the UK, the latest Bank of England forecasts of an eye watering peak in inflation and five consecutive quarters of negative growth are likely a very attractive projection by which to benchmark your tenure and performance.

Indeed, the BoE forecasts are significantly more negative than their peers.

Secondly, it was made very clear by Governor of the Bank of England and Deputies Governors, that the vast majority (Broadbent would not be drawn in the exact percentage, but implied much if not all) of the inflation pressure is a function of external factors - predominantly gas prices. Indeed, the Deputy Governor alluded to the fact that the current direct contribution of the gas price to headline inflation is of the order of 6.5% (with additional substantial indirect contributions). However, the Bank’s baseline projections are based upon the current spot gas price, gas futures curve for the next 6 months and then flat thereafter. It is therefore very possible that the BoE projections at the current juncture extrapolate for an extended period, the current acute stress in the energy market. A factor that may significantly overstate the inflation trajectory.

A lone, dissenting policymaker, at the Bank of England expressed her view that “Bank Rate might already have reached the level consistent with returning inflation to 2% in the medium term”. Given the external stress the UK consumer is facing, it is difficult to push back against this point of view - especially under the thesis that most, if not all excess inflation (i.e. that above the target level) is a function of supply side dynamics over which the BoE has no control.

The central view of the Bank remains that taking more forceful action now will prevent them from having to take more forceful action later. However, from my perspective this is difficult to square with a supply dominated inflation and a central forecast of inflation so far below target at the forecast horizon to warrant concern. Indeed, a central forecast of inflation at 0.76% at the forecast horizon would, under any other circumstances, warrant policy easing, not tightening. Markets are currently pricing a terminal rate of above 3.0%. This looks increasingly inconsistent with a backdrop of extreme (and prolonged?) external pressure on consumption - as consumption faces increasing pressure from a more pernicious real income squeeze.

One last point on the matter is that the uncertainty of the macroeconomic (and geopolitical) backdrop that leads the Bank to state that it is currently placing a lower weight on its central forecast from the August MPR are also represented in the fact that alternative forecasts are radically different. The Bank sees a 2023 calendar year change in GDP of -1.5% (as part of 5 quarters of negative growth that wipes 2.3% off of economic output). The same forecasts from the NIESR (National Institute of Economic and Social Research), the IMF and the average of independent forecasters surveyed by HMT are +0.5%, +0.5% and +0.6% respectively! Again, much of this will be a function of assumptions on the fiscal response, the path of gas and supply driven inflation as well as the resilience of the consumer.

Ultimately, at least in part it is all about communication. The Fed went through a period whereby it communicated iteratively more hawkish policy pivots and demonstrable front loaded, inflation focussed rate hikes in an attempt to regain control of the inflation narrative. The Bank of England may well be in part using the message of recession as a communication tool to regain control of the narrative - in terms of the concern over de-anchored long run inflation expectations.

In this context, recession is likely a very unhelpful term. The suggestion that all recessions are the same or that there is a binary point at which things go from wonderful to terrible is inaccurate. We remain far more positive on the prospects of the US and the Fed in terms of avoiding a ‘recession’ as excess demand remains and the energy price driven income squeeze is far smaller. In the UK (and ultimately in the eurozone too) the energy price issue will likely cause a more negative growth outlook for a while (even if the Bank are perhaps more pessimistic than I would be personally). In the near term, UK growth is a lot further away from its respective nirvana, perhaps it really is less dangerous “with the lights out”, for a while at least!

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