“The sun shines on the black clouds hanging over the domain"
- Crowded House, Four Seasons in One Day
Last week we discussed the significance of what we described as a linear pivot (an extrapolated positive view of economic progress and monetary normalisation expectation) by the Federal Reserve (Fed) as a milestone for the extrapolated divergence of global monetary policy. Furthermore, we also highlighted our view that, with US growth now above its pre-pandemic level, the monetary impulse will continue to be positive (at least relative to the pre-covid era) through all of the normalisation projected in the Fed dots. Thus, we argued, US rate divergence can continue to be supportive of growth, and therefore, USD outperformance.
However, it is not clear that the current inflation / growth dynamic is so supportive for the rest of the global economy. In many respects, the US is more insulated from the current inflation surge (especially from energy), and thus the US rate normalisation can be seen as tightening for positive reasons. Outside of the US, cost push inflation has less positive implications.
Indeed, in some parts of the world, it could certainly be argued that the acute price pressures (driven by energy price rises, supply bottlenecks, covid, labour market frictions...) are likely destabilising for medium term growth prospects. For example, the hiking cycles in Russia and Brazil have been aggressive and persistent, yet headline inflation rates remain elevated. Obviously, it is not as simple as this; central banks target financial stability with a keen eye on medium term inflation expectations, and it is not clear that these expectations have not remained more well behaved as a function of central bank tightening. But at what cost to growth?
The National Bank of Poland (NBP) President long argued that it would be “foolish” to raise interest rates in the face of “transitory” inflation pressures that are not a function of domestic demand (and thus sensitive to domestic interest rates), only to be strong-armed by a mutiny of ex-NBP presidents and Monetary Policy Council members, an energy price crisis and persistent supply pressures – this week the NBP hiked a surprise 40bps! Only time will tell if the NBP President was right (initially), but there is clearly a risk against such a complicated global backdrop that central bank tightening has little impact on inflation (of external, transient origin) but a big, negative, impact on growth!
Step forward the Bank of England (BoE).
This week was the annual (ex-2020 due to covid) Conservative Party Conference, where the PM outlined a long-term vision of a “high wage, high skill, low tax economy”, in a “long overdue change in direction” to becoming an “evermore global payer”. The vision was fresh with hopes of Pareto improvements (key to the levelling up agenda), where continued growth is key to the continued economic recovery and, importantly, the prospects of ‘filling’ the “huge hole in public finances”. However, the BoE response over coming months / quarters to the very complicated inflation / growth / policy reaction function dilemma will likely be a crucial part of the prospects of the PM’s vision of the future becoming a reality.
The UK, at least with reference to the developed market space, has likely seen the most acute price pressures - from the idiosyncratic issues surrounding internal distribution and logistics, to the reliance on external energy sources and even the labour market frictions that have arisen from the covid / furlough / Brexit dynamic. The BoE Governor suggested that this is a combination whereby “covid has amplified the impact of other shocks - either that or the gods really are against us”.
The Governor went on to state: “there are many factors adding to higher prices that would be transitory” but “the recovery is weakening. A lot therefore turns on how effectively supply capacity is rebuilt, and over what time, and how the labour market evolves. These are truly hard yards.”
Markets have taken a very negative view of inflation in the UK, with breakevens rallying fast over recent months, as gas prices across Europe surge at precisely the wrong time for anyone other than natural gas producers! Indeed, UK 10y breakeven yields jumped from around 3% at the start of the year, and 3.6% at the end of August to above 4% this week, adding further pressure on the BoE to assert their inflation fighting credentials.
To add to the complexity, the jobs market is potentially at an inflexion point, as 1.3m people (or 5% of the workforce) were on furlough at the end of August - a pandemic support measure that expired at the end of September. On the positive side, there are a record number of job vacancies in the UK (above 1m), but it is not clear what the transition from furlough to employment will look like (speed, persistence), and thus what the oscillations of the unemployment rate will be. The near term uncertainty in both jobs and consumer demand is further exacerbated by the expiration of the uplift in Universal Credit (UC), a benefit paid to those on the low end of the income distribution, with as yet unknown implications for consumption - not to mention the impact of the further fiscal tightening from the rise in Corporation Tax and the Health and Social Care Levy (NIC).
In short, the delicate balance of growth and inflation carries significant risks to the UK. If the current pernicious confluence of inflation pressures persist, then the BoE will likely be forced to act to prevent the destabilising of medium-term inflation expectations. However, in acting, the BoE risks turning an economic stutter - perhaps exaggerated by the end of furlough and the PM’s (and Chancellor’s) gamble on ending the UC uplift and raising taxes - into something far worse, undermining or even reversing the recovery.
Personally, I retain a positive view of the UK economy, as this week’s financial sector jobs data suggest (record vacancies). Furthermore, from a currency perspective, GBP valuations remain cheap and the current backdrop remains supportive of further gains relative to the EUR (at least from a rate divergence perspective).
However, the PM’s vision of post-Brexit Britain likely faces a nail-biting few months, not just in terms of his government's fiscal tightening, but in the hands of the BoE. In the words of a previous Conservative Chancellor, it is prudent to “fix the roof while the sun is shining”; however, there are some angry looking clouds forming on the horizon, that I for one hope will blow over!
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