The Bank of England delivered a 0.5% rise in the Bank Rate last week. This came after an even bigger move by the US and a similar hike by the European Central Bank. We explore the reasons behind the hikes and ask what will it take for us to see an end to the rises?
Although inflation is at a similar level in Europe and the US in headline terms, the composition is quite different. In the UK and euro area, energy prices are the chief culprit with gas prices leading the way. In the US, domestic pressures predominate. Wages there are rising strongly – much faster than in Europe – as are rents.
Did the Federal Reserve act too slowly?
Last week’s surge in employment highlights just how strong the US labour market is, and I can’t see a scenario in which these pressures are contained without a recession. That means the US Federal Reserve will likely have to keep raising rates until a recession is imminent. And given the underlying strength in the US’s economy I expect US interest rates to head much higher because, in my view, they left it far too late to start tightening.
Further rate rises in the UK and euro area could be modest
It is a different story in Europe. The futures prices for natural gas this winter are 12 times higher than it was before Russia invaded Ukraine. That is a huge increase. The UK faces a smaller increase but the tenfold rise is still unprecedented. The result, in my view is a recession. But this will be different type of recession than in the US. It’s a supply shock that doesn’t need a monetary policy response. Gas prices are not going to rise 10-fold again and markets are pricing in a medium-term decline. So, much of the rise in inflation will be transitory and because the hit to real incomes will generate a recession anyway there’s no need for the central banks to do more on this account.
Now that’s not the whole story: interest rates went to near zero in the UK and negative in Europe, so they are trending up to more ‘normal’ levels and considering other factors I suspect that the Bank of England and European Central Bank may only raise rates a little further from here.
Implications for markets
Recessions are bad news for corporate earnings, whether or not they reflect a supply shock. And higher interest rates combined with a recession constitute a double whammy. After a truly terrible first half year, equities, and bonds both preformed well in July. And equites have started August well overall. But I think they are in for a challenging few months.
As for the US versus Europe, once inflation pressures ease in the US, the Fed can contemplate cutting rates or, at any rate putting policy on hold. At that point corporate earnings and equities can begin to recover. No doubt European equites would be benefit from this to some degree. But even if gas prices here come down a little, it’s hard to see them returning to previous levels any time soon.
Inflation needs to be brought under control – and that will be painful.
The rally in risk assets has occurred for the seemingly perverse reason that economic data weakened. This led markets to conclude that the US Federal Reserve will raise interest rates only a little further and will be cutting them in 2023. Equities have fallen so far in 2022, despite strong earnings growth so surely equities are a ‘buy’ if interest rates stop rising?
The big flaw in this argument is that it suggests that interest rates are close to a level that will subdue inflation and that this will occur without a recession. The reality is that US inflation has been allowed to get too high and is too persistent to be quelled by a mere slowdown in the economy. Yes, US GDP contracted in the first two quarters of 2022 but that is not a sensible reflection of the economy. After all, the US economy added a stunning 2.7mn jobs in that period. Wage inflation has accelerated strongly this yar – faster than the Federal Reserve and the markets expected. The same applies to rents. Yes, gasoline prices have fallen from lofty levels and other commodity prices have declined but these factors have a trivial influence on inflation compared with rents and wages.
In my view, the US needs a proper recession including a significant rise in unemployment to get inflation back down towards the Fed’s 2% target. And that probably needs significantly higher interest rates which will be accompanied by a fall in corporate earnings.
Investors already expect recession – but equities could well head lower.
It is true that investor sentiment became exceptionally bearish a month ago and most expect a recession. It may therefore be that equities don’t have too far to fall from here, but my guess is that they are still headed lower.
We can hardly expect Europe to deliver much support. Unlike the US, wages and rents are not the major source of inflationary pressure. In Europe it’s the cost-of-living crisis that dominates and it hard to see how Europe avoids a recession as energy bills soar. The numbers are scary. For the UK, the average home energy bill is set to exceed £3,000 in October and then rise again towards £4,000 in January 2023. Yes, some of this will be offset by government support but that will only mitigate the impact, it won’t protect industry and will be a further constraint on the public finances. Conditions differ in other European countries but for northern Europe and Germany in particular, the outlook is grim.
