Two shades of policy
Over the past week, both UK and US central bankers have indicated they finally see a more sustained uplift in inflation over the ambiguously named ‘medium term’, which is increasing expectations of policy tightening. Well, that’s good news from an economic standpoint because it indicates that demand is driving higher prices—a sign of a hot economy. It’s unclear what ‘policy tightening’ actually tells us about their upcoming policy decisions and their consequences for rates and FX markets.
Over the past several weeks, we’ve made the case that interest rates are unlikely to rise in the near future, but highlighted that there are other policy levers the Federal Reserve and Bank of England might use to achieve their desired outcome of controlling inflation. The first thing to acknowledge is that there’s a growing consensus for a lighter approach, less use of broad policy tools like interest rates and a bigger emphasis on more targeted approaches that might tackle some spiralling asset prices but apply the brakes on economic activity more lightly.
The basis for our interest rate view was an uneven inflationary impact on demand-driven inflation—an increase in purchasing driving prices up—and supply-side inflation—a reduced amount of an asset making the price higher. Among other catalysts, Covid has decreased supplies in raw materials or limited the capacity of services, which has driven supply-side inflation. However, now the story pivots because the central bankers have signalled sustained demand-side inflation on the horizon.
The Biden administration is due to elect a Chairman of the Federal Reserve, and Lael Brainard—the sole Democrat on the Federal Reserve Board of Governors—is a leading candidate for the posting. Her recent public remarks indicate that she favours a more aggressive approach to asset bubbles but less liberal use of the main interest rate as a tool. This suggests that interest rate rises are less likely; indeed, Senate oversight and other Reserve Board members are discussing the halt of asset purchases instead.
A very similar inflation signal has been declaimed in the UK, but in the BoE’s case policymakers have said that rate hikes up to 0.5% will proceed quantitative easing downscaling. This sort of message seems to indicate that demand is stronger than it actually is—because of the policy tool being employed—but there’s a logical rationale one should consider. The BoE simply prefers to see how the Fed’s QE taper works before attempting its own; so instead, policymakers will make a first modest step with their known policy tool, interest rates.
Bottom line: While QE purchases have helped drive interest rates lower, the impact hasn’t been uniform across the interest rate curve, by design targeting near-date maturities over longer-dated ones. The consequences of unwinding QE are a bit of an unknown but it’s likely to cause some steepening in short rates that impact FX forward markets. That said, the impact is expected to be modest compared to a rate hike, which means we may see a more pronounced move in UK rates than US rates simply because of the initial policy response. We’d expect that effect to moderate as both central banks focus on their bond holdings in due course.
The week ahead
Sterling traded relatively flat last week on a trade-weighted basis but managed to finish in the green for the third consecutive week. The BoE’s latest monetary policy announcement was the main event. BoE Governor Andrew Bailey announced ‘some modest tightening’ will be required if the bank is to achieve its 2.0% inflation target in the medium term. Echoing other major central banks, Bailey reiterated that most inflationary pressures are expected to be temporary. The UK data calendar is light in the week ahead, with Thursday’s GDP print the key release to watch.
- Thursday’s preliminary estimate of UK Gross Domestic Product quarter-on-quarter to Q2 is 4.8%, up from -1.6% previously, while the year-on-year reading is expected to be 22.1% versus -6.1% previously.
- Also on Thursday, Industrial Production for June is forecast to show 0.5% growth month-on-month, while Manufacturing Production is predicted to come in at 0.4% month-on-month.
On a trade-weighted basis, the Euro index posted its lowest reading since July 2020 as policy stances between the European Central Bank and other major central banks continue to diverge. The Euro approached 17-week lows against the US Dollar, while the common currency touched its weakest level against the Pound since February 2020. The Eurozone data calendar is sparse this week, but last week’s strong US Non-Farm Payroll figure sent the Euro tumbling, and this week’s US inflation data and Federal Reserve speakers may drive EUR sentiment further in the same direction.
- On Tuesday, German ZEW surveys for August are forecasting a downtick; the Expectations Survey is predicted to fall from 63.3 to 56.0, while the Current Situation Survey is pegged to improve from 21.9 to 30.0.
- On Wednesday, the final German Consumer Price Index reading for July is estimated to print at 0.9% month-on-month, while the year-on-year reading is predicted to be 3.8%; both forecasts are unchanged from previous estimates.
The US Dollar index finished strong last week after a disappointing week prior as Non-Farm Payrolls data beat the estimate, and the previous month’s figure was revised higher. An improving US labour market is key to the Fed’s threshold of ‘substantial further progress’ in the US economy before monetary tightening takes place, and last week’s data certainly added weight to the argument. Post-release, the US Dollar index nearly doubled the gains it had made during the week and has since been trading less than 1.0% away from its year-to-date peak. This week, the key USD events will be Wednesday’s inflation print as well as speeches from several Fed members.
- Wednesday’s month-on-month CPI estimate for July is expected to come in at 0.5%, down from 0.9% in June, while the year-on-year reading is forecast to print at 5.3%
- On Thursday, Initial Jobless Claims is expected to show 375k people claiming unemployment in the previous week, down from 385k in the previous print.
- Friday’s University of Michigan Sentiment survey for August is estimated to remain unchanged from July’s reading, at 81.2.
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