PERSISTENTLY HIGH INFLATION INCREASES THE CHANCES OF FURTHER INTEREST RATE HIKES

PERSISTENTLY HIGH INFLATION INCREASES THE CHANCES OF FURTHER INTEREST RATE HIKES

This week the Bank of England’s job appeared to get harder as it faces the problem of trying to tackle inflation without doing significant damage to the economy. Inflation running in double digits since September is very bad news, and when you add a strong employment market and private sector wages rising at more than 6% a year it is easy to see why markets are predicting further interest rate rises. Gilt yields extended their recent rise as investors now see rates increasing to 5% this year. But there are already strong signs that the UK’s economy is slowing down.

After being kept artificially low by government Covid-era support and ultra-low interest rates, insolvencies have jumped sharply. Consumer confidence is still very negative and retail sales are falling fairly quickly. There is also evidence of an economic slowdown in the US. The Bank of England may be tempted to act decisively in the short-term to help reduce expectations of future inflation. However, inflation is likely to fall quickly as energy prices fall out of the annual calculation and the risks of a hard landing, partly due to aggressive rate hikes, are coming in to view.

UK: HEADLINE INFLATION REMAINS ABOVE 10%

Inflation was more resilient than expected as the Consumer Prices Index for March came in at 10.1%. CPI has now been above 10% for seven months. In contrast, Europe and the US have seen inflation fall significantly. Food and housing were the biggest contributors, with the cost of food up 19% annually. Core inflation (excluding volatile food and fuel costs) also remained resilient and was unchanged from February. There are downward pressures on inflation with some supermarkets saying they expect prices rises will slow and falling fuel costs will also soon appear in the annual inflation figure.

The UK’s jobs market remains robust as more people return to the workforce and wages continue to rise much faster than the long-term average. The potential for higher wages to fuel inflation means markets are expecting interest rates to rise to 5% this year. This helped sterling continue to rise against the dollar. There are signs the economy may be feeling the effects of higher rates, as company insolvencies have increased significantly.

US: FED SEES THE ECONOMY SLOWING AS BANK PROFITS FALL

The US economy is showing signs of cooling, according to the US Federal Reserve. Its says hiring and inflation are slowing down, and access to credit is becoming harder. The reduction in lending is expected to accelerate as banks become more cautious following the collapse of Silicon Valley Bank. This drop in borrowing is likely to curb consumer activity and the Fed has forecast consumer spending will be flat or fall slightly.

Many of the big US banks have delivered stock market updates. Many reported a drop in deposits as assets flowed into higher-yielding money market securities. Several banks have reported a decline in trading revenues but other updates were more positive. JPMorgan reported a big increase in quarterly profits due to higher interest rates on its lending. Bank of America also said profits were up and said it sees no sign of a slowdown in consumer spending and borrowing. However, there were warnings that recession remains a possibility and some banks are increasing the amount they set aside to cover bad loans.

CHINA: RETURN TO GROWTH AS ECONOMY SHAKES OFF COVID EFFECTS

Chinese economic growth exceeded expectations as activity continues to recover from the country’s strict anti-Covid measures. GDP grew by 4.5% in the first quarter of 2023 after China relaxed its health restrictions in December. China has also reported a recovery in trade as March exports increased 14% and industrial production exceeded expectations. Retail sales have also recovered strongly, as sales were 10% higher than a year ago. Even China’s struggling property sector is showing signs of recovery as the government’s attempts to restore consumer confidence show some success. The average price of new homes increased by 0.5% in March, following a 0.3% rise in February.

China’s economic recovery has coincided with a recovery in Chinese equities. Lower economic activity combined with more intrusive regulation saw Chinese shares fall by 30% between January and late October 2022. Chinese equities have risen by 30% since then, comfortably outperforming broader emerging markets region.