Financial Update from Brewin Dolphin - 16 June 2023
The Weekly Round-up
Friday 16 June 2023
In his latest weekly round-up, Guy Foster, our Chief Strategist, discusses this week’s major central bank meetings and ponders the impact of artificial intelligence on inflation.
This was a big week for bonds and currencies with interest rates in focus, mainly because of the glut of major central banks meetings, but also because of the sense that we might be reaching the top of the interest rate cycle over the coming months.
The Federal Reserve, European Central Bank (ECB) and Bank of Japan all set interest rates this week.
The Federal Reserve went first. Its decision came a day after the May consumer price index report. The annual rate of inflation in the US has been on a downward trend. That trend, however, belies some recently firm monthly core inflation numbers. A lot hinges on the substantial shelter component, which is correlated with, and lags, house prices. We can therefore see that shelter inflation should slow over the coming months, and that should in turn weigh down core inflation. There’s no room for complacency though. Recently, the housing market has been showing more signs of life. Core services excluding shelter – so-called ‘supercore’ inflation – picked up during May.
So, against this background, and Fed speakers having signalled that the committee might skip the current meeting before resuming raising rates in July, the Federal Reserve decided to leave interest rates unchanged. What stood out about this inaction was the change in economic projections. Rates are still expected to rise by an additional 0.5%, implying two more interest rate increases than it had previously expected. Understandably, some questioned why the Fed would effectively be slowing its pace (by skipping meetings) whilst also expecting to go further. The market has been forced to unwind some of its interest rate cut expectations but remains sceptical that the Fed will raise above 5.5%. Typically, at this point in the economic cycle, policymakers will gauge their actions according to the progression of economic data. This week, US retail sales held up better than expected but initial jobless claims and factory output suggest the economy is slowing, if not stalling.
The problem with responding to data is that by the time you do so it may be too late. This is perhaps why interest rate cycles lead to recessions more often than not. Fed chair Jay Powell seems to believe that the lags between implementing monetary policy and feeling its effects are shorter than in previous cycles. Additional factors are the unwinding of asset purchases, which continues even as the interest rates increase was skipped this month, and the repayment of emergency programmes offered to banks in the aftermath of Silicon Valley Bank’s failure. Both factors serve to reduce liquidity in the market and therefore represent de facto tightening.
The backdrop to the ECB’s latest pronouncement is that the eurozone seems to be in a recession (having suffered two quarters of very modestly negative growth). This reflects a global trend of manufacturing activity contracting but being offset by stronger services activity.
Despite the weak growth backdrop heading into yesterday’s meeting, and the fact the ECB slightly revised down its expectations for GDP growth this year and next, it went ahead and hiked its key rates another 25 bps, with the deposit rate rising to 3.5%. The reason for doing so was inflation.
In the statement, the ECB made clear that the rise in its inflation projections reflects both past upside inflation surprises and the robust labour market. As you might expect, when juggling weaker growth and inconclusive evidence of moderating inflation, the ECB has joined the data dependent club.
Proxies for European growth, such as the growth of the money supply or tightness of lending standards, still suggest further weakness ahead. Investors see two more rate hikes as likely. A headwind for Europe is the underwhelming recovery in China.
Despite its recent emergence from Covid-zero suppression measures last year, China has fallen into lockstep with the rest of the world in terms of having a stronger services sector than manufacturing sector. But even against fairly modest expectations, retail sales showed signs of faltering, house prices are stagnating and fixed asset growth, which has historically driven demand in the past, is being held back during this cycle, leading investors to question where the growth is going to come from. Stimulus is needed and so interest rates have at last started to be reduced, albeit by a modest 0.1% to the medium-term lending facility. More easing is expected to follow.
Although Japan also suffers from the gulf between services and manufacturing activity, it has not, so far, tightened monetary policy. Speculation has been mounting as the current yield curve control policy distorts the Japanese bond market whilst seemingly doing little to change trends in consumer prices. For the moment, these are above the Bank of Japan’s target, although underwhelming wage growth suggests it may not sustain the velocity needed to achieve a labour market-driven escape from disinflation. This month, new governor Kazuo Ueda left policy unchanged. He has already instigated a review of policies like yield curve control. It seems likely that it will be abandoned at some stage, although speculation to that end has ebbed in recent weeks. The yen weakened in response to the decision. Ueda, like many other policymakers, seems to have a different disposition towards monetary policy now that he is in office compared to when he was in academia (and seemed of a more hawkish persuasion).
In all the discussions of inflation, the elephant in the room is artificial intelligence (AI). The impact is difficult to gauge. On the one hand, a supply-side boost should reduce inflationary pressure. On the other hand, the investment needed to implement AI solutions would likely put upward pressure on rates. Productivity gains can be seen as increasing the potential rewards from invested capital, and as such should require higher interest rates to compensate savers for the opportunity cost they suffer by not taking risk. But what is unknown is whether widespread adoption of AI could weaken demand if it led to extra labour market slack.
All this and more must be pondered as we embrace rapidly changing technology.
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