Any move likely from the Bank of England tomorrow and the Fed next week ? No ..... just a lot of head-scratching.

Wednesday 13th September 2017

Any move likely from the Bank of England tomorrow and the Fed next week ? No ..... just a lot of head-scratching.

ref :- "Act or Wait ? Fed Debate Heats Up After Inflation Misses Target " , Bloomberg Markets

"The value of Sterling is largely a function of the Brexit process .... discuss." 

The answer to that one is "Yes of course ..... on the way down and indirectly, and a little ironically, on the way up too" . Without doubt the concerns over how Brexit, and especially a messy Brexit, might adversely affect the UK's economic performance have been the driver behind the Pound's fall from $1.49 to the low $1.20's (at one stage), and from €1.30 to €1.08. But notwithstanding the Dollar's malaise that allowed Sterling to rally to $1.28, one could argue that its more general recent bounce to above $1.33 and €1.11 is, if not exactly a function of the Brexit process, then a reaction to it.

Particularly for a big net importer like the UK, a lower currency begets higher prices. If inflation gets much beyond desired levels (2% is currently the magic number in most developed nations), the conventional method for a central bank to tackle the problem is to raise interest rates. Higher interest rates attracts capital inflows and boosts the currency ..... and it was perceptions of an  increased chance of a rate hike in response to strong UK inflation data released earlier this week (2.9%) that was behind Sterling's latest bounce.

Sterling has backed off a little from its highs this morning, after data showed that despite a 4.3% reading for headline unemployment, wage rises are still bumbling along at a gentle 2.1% and will not strengthen the hand of the hawks on the Bank of England's monetary policy committee when it makes it's decision on rates tomorrow. Nevertheless, recent market action does reflect the BoE's dilemma quite nicely : higher inflation numbers normally imply rises in rates but falling estimates for growth and lacklustre wage rises do not.

Expect a more urgent discussion of the issues, but no change in rates is likely and investors will be looking to see if the 7 - 2 majority for no change that we saw last time has narrowed any.

There is effectively NO chance of a rate hike at the US Federal Reserve's meeting on Sept 19/20th, though almost certainly they will announce the start of the gradual reduction of the Fed's $4.5 trillion balance sheet accumulated through the Quantitative Easing programme. Being widely expected it should have little market impact initially, and the Fed will hope that it will indeed remain the "policy equivalent of watching paint dry", as Philadelphia Fed boss Harker put it. We'll see ..... there are those that argue that at some point down the line, as bonds held by the Fed mature and are not replaced on its balance sheet, it must squeeze yields higher  --  just as the original purchases pushed them lower.

As ever, the market will be intent on detecting clues as to the likelihood of a rate hike in December  --  something that up to now at least has been the Fed's stated expectation even if the market believes the chances of such an event are only around 40% (they have been lower). In common with most developed economies but in stark contrast to the UK's Brexit-related issues, the Fed's problem is a LACK of inflationary pressure.  A majority on the Fed board adhere to the old Phillips Curve  --  you know, the theory that as unemployment falls, inflationary pressures rise  --  despite the fact that things have not worked out that way so far in this cycle. For them, it's just a matter of time.

But that doesn't mean that even those on the mildly hawkish side of the argument , like the New York Fed chief William Dudley, are entirely ruling out the possibility that something fundamental may have changed in the levels of inflation generated by modern economies, and in particular by the link between inflation and levels of employment. Is the current stubbornly-low rate of inflation at a time of low unemployment driven by "transient, idiosyncratic factors", or is there something "more secular, longer-term at play" ?

As Mr Dudley also said , the jury's still out. Half the problem is that if the nature of inflation has changed, no one is 100% certain what precisely has brought it about  --  Demographics ? Automation ? Work practices ? The internet ?  --  and in what proportion. If you can't identify the exact cause, it's difficult to set appropriate policy.

We'd hope to hear something from the Fed on the High Employment / Low Inflation conundrum, but doubt whether they'll specifically address a fundamental question that the Bloomberg piece raises about their own role : if previously-held theories about inflation are no longer sound, should they be taking preemptive action to ward it off, something that has long been at the heart of modern central banking ?

NOT taking preemptive action runs the risk of letting the economy run too "hot", inflation-wise. Some would argue that it's worth it in the short-term if it helps secure continued growth. The hawks would grumble, but at least the old economic theories at the heart of their thinking would be validated once more. But what if the Fed does nothing, respectable growth continues and inflation still remains below target ? That would mean something has really changed and the Fed  --  and every other central bank  --  would have to reconstruct their game plan entirely.