Chief Economist’s Weekly Briefing – A Rocky Road

Last week interest rates were hiked by the largest amount since the Bank of England gained independence in 1997. But it was the further hike in the estimated inflation peak, with it set to remain higher for longer, as well as a forecast recession that ultimately grabbed the headlines. Conditions outside the UK are little better, confidence in the Euro area is dropping and Chinese PMIs are contracting as the impetus from reopening fades.

Here comes the R-word. In Its August Monetary Policy Report, the BoE yet again raised the estimate of inflation to a peak of 13% in Q4, with the energy cap rising by a whopping 75% in October. More notably, the economic outlook has materially deteriorated, with the BoE now projecting a 5-quarter recession lasting until end-2023 that shaves 2% from GDP.  Admittedly, there are a lot of conservative conditioning assumptions – e.g., on future rates path, energy prices and fiscal support. But even accounting for those, the outlook is challenging, and that’s putting it mildly. Despite the BoE also projecting that inflation would return to target even with no further rate rises, markets are pricing for at least a further five 25bps hikes.

No surprise. In line with market expectations and based on BoE’s revised projections, the Monetary Policy Committee (MPC) voted 8-1 in favour of hiking the Bank Rate by 50 bps to 1.75% in its August meeting. This was the sixth consecutive rise. The MPC continued to warn that it “will be particularly alert to indications of more persistent inflationary pressures, and will if necessary act forcefully in response”. However, MPC’s statement that “policy is not on a pre-set path” suggests that it is uncomfortable with markets’ pricing five rate hikes from here. With the economic outlook drastically downgraded, the end of the tightening cycle may be sooner than many expect.

The fightback. But for many that would be a bold move, with signs of inflation pressure coming down the track remaining very much visible. For example, the BoE’s own survey points to firms hiking output prices by 7.9% in the year to July. More pressingly, business leaders now expect to raise prices by a further 6.6% over the coming year (up 0.3 ppts since last month) and raise wages by 5.2% (up by 0.1 ppts since June). That pace of growth, if sustained, is far too high to be compatible with the BoE’s 2% inflation target. Cue the fightback from monetary authorities last week, who are determined to curb those excesses and stop businesses’ expectations that inflation will still be running at 4.1% in three years’ time from becoming self-fulfilling.

Mixed. Consumer activity fared strongly in the week of 31st July, with notable week-on-week increases in UK seated diners (12 ppts) and “park” visits (+8%). Card spending grew in all sectors with the strongest  growth (18ppts) being in “retail spending”. But the impact of Russia cutting gas flows to Europe was striking, leading to a 31% increase in the preceding seven-day rolling average wholesale gas price in the week of 31st July, taking the series to its highest level since 16th March. Elsewhere, the business and workforce indicators showed a varied picture with a 2% fall in the volume of online job adverts and a 19% increase in company voluntary dissolution applications. The economy is trying hard to stay afloat, even as crippling inflation drags it down.

Costly. Around 9 in 10 adults (around 46M people) in Great Britain reported that their cost of living has increased at the end of July. This is an increase from around 6 in 10 (32M adults) in November 2021. People report the following reasons: an increase in the price of their food shop (94%); an increase in gas or electricity bills (82%); an increase in the price of fuel (77%). To deal with raising cost of living around 24M people were reducing energy use in their home between March and June 2022, and around 16M cut back on food and essentials. The policy support in response to these pressures become ever more significant with each passing week. 

Still strong. The US may be in a technical recession but it’s not ready to throw in the towel just yet. Payroll numbers for July were very strong, coming in at 528k, more than double the estimate and being widespread across sectors, led by leisure & hospitality, professional and business services and health care. The unemployment rate fell to 3.5%, a fresh post-pandemic low. Separately a survey of services sector activity also came in ahead of expectations. But concerns are still visible. Initial jobless claims (more a leading indicator than payroll growth) continue to inch higher while higher rates are taking the heat out of housebuilding. Further, some businesses express worries about cooler demand. So it’s likely to be more rocky here, too.

Stable. The euro area unemployment rate remained stable at a record low of 6.6 % in June (vs May), down from 7.9 % in June 2021. However, forward-looking indicators point towards some slack developing in the labour market. For one, the pace of employment growth is slowing; services employment index rose in July but at the softest rate in the last five months. This in turn is driven by firms’ confidence slumping to a 21-month low amid concerns around soaring inflation, rising interest rates and supply worries – notably for energy. Moreover, labour supply is likely to rise as Ukrainian refugees are incorporated into labour forces over the coming months across the Euro area, which should ease at least some element of labour shortages.

Faltering recovery. With the boost from reopening subsiding, China’s PMI reading suggests that the recovery in activity may be fading. Factory activity contracted in July as new coronavirus flare-ups and stress in China’s property market weakened demand. The official PMI for manufacturers fell back to 49 in July from 50.2 in June, with Caixin index telling a similar story. The drop was led by falling output and new orders. Price pressures slowed notably in July. Softer demand both domestically and externally, along with supply-side factors from tighter restrictions weighed on recovery. Meanwhile, non-manufacturing PMI fell to 53.8 from 54.7 in June. Following anaemic growth figure for Q2 and the constant threat of more lockdowns, the recovery path seems slow and fragile for the world’s second-largest economy.

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