Central Banks - None the Wiser

16 June 2017

While politics and another desperately sad case of corporate man-slaughter dominated UK news, economics at home and abroad were dominated by central bank policy action, in-action and signs of rate setting committee dissent.

Global stock markets appeared content and except for a 3-5% correction in the exceeding highly valued US tech sector traded sideways at their recent highs.

On Wednesday, the Federal Reserve Board had raised their target short-term rate to 1.25% (from 1%) as had been widely expected for the past month. However, more importantly they also indicated a plan on how to start a 'tapering' of their QE bond holdings in 2017, again in line with expectations, but without a definitive start date. The Fed's rhetoric accompanying the announcement imparted confidence in the economy and gave markets a sense of only marginal tightening of policy. US government bond yields rose marginally across the curve, but not enough (by itself) to undermine the equity market.

On Thursday, apparent dissent amongst the Bank of England's (BoE) Monetary Policy Committee provided more of a shock. Although there was no change in the 0.25% 'base' rate, three members of the eight saw the need for a hike.

Before the meeting, the UK economy's data readings had given rise to generally at least mild concern as they had been the equivalent of steady drizzle (soggy and grey). Despite employment rising to record levels (and unemployment remaining at only 4.6%), employees' pay rose only 1.7% over 12 months, which against a 2.9% rate of inflation amounted to a pay cut. Unsurprisingly, retail sales volumes for May showed a decline of 1.2% from April, leaving the change over the year at a measly +0.6%.

So why would the three MPC members think that people needed a rise in mortgage costs?

Well, it would have been concerns of inflationary pressures as prices of 'core' goods (the things we generally have to buy) rose 2.6% in the 12 months to May. The old measure of inflation, the Retail Price Index, rose 3.7% in the year.

While that's good news for those on index-linked pensions, employees on low wages are badly affected because 'core' goods form a greater proportion of their spending than those on higher wages.

Underlying this inflation rise has been the weakness in the pound. In the graph below, Jim has tried to show the influence that the fall in our currency has had on UK inflation (the old RPI, because the data has a much longer history). The red line shows changes in the RPI versus 6-months ago, while the dotted blue line shows a measure of how sterling's fall has added to inflationary pressure. (This has been pushed forward to show how it exerts influence in the near future). As one can see, the pressure to push inflation higher can be expected to remain strong into the year's end if the relation in the past continues to have relevance for the future.

To us this clearly suggests that the current spike in inflation is transitory and therefore not policy relevant, whereas the same cannot be said with the same conviction about the economic slowdown since the beginning of the year. In a separate article below - Unwinding of QE - first appearance on the horizon - we comment more broadly about what we take away from a week filled with central bank announcements.

As a contrast to the UK, the May inflation data from the US, Europe and China came out on the low side. China is of particular interest. For three out of the past four years, it has been the source of deflationary pressure. The past year saw a sharp reversal, as the government eased fiscal and monetary policy. However, 2017 has seen a reversal of that easing, culminating in May's producer prices declining again.

While China has backed away from outright monetary tightening in recent weeks, their actions have been felt quickly across the world in goods price terms, and so inflation pressure has dissipated as quickly as it arose.

So, for the UK, our best guess is that soft final domestic demand and lack of external price pressure will leave the only pressure coming from the after-effects of sterling falls. This should mean that the incentive to raise rates will lessen over the next few months.

Coordinated economic strength across the world through the second half of 2016 caused optimism over company earnings prospects. Now, much of that synchronised strength and improved business and consumer sentiment has receded and is now only found in the previous concentration in Continental Europe and parts of Asia. There is a slight concern that the new leaning towards monetary tightening of central bank's from China, to the US and now even the UK may prove premature and might even have already tipped activity into coordinated softness. This may mean that after encouragingly strongly corporate profit growth in the first quarter of 2017, analysts' extrapolation of those growth rates may prove similarly premature and lead to renewed earnings pessimism in the second half of 2017.

As mentioned at the start, equity markets continued to trade at their highest levels this past week. At the same time, stock market volatility has picked up, both in actual stock price movements and in the price of options on those stocks. We expect things to get even rockier over the next few weeks, with increased stock market volatility no longer just focused on the highly valued US tech sector.

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