Jupiter Merlin Weekly: The Bank of England seems stumped by inflation
Jupiter Merlin Weekly: The Bank of England seems stumped by inflation
The Jupiter Merlin team look at the latest inflation data. While in the US the figures are open to interpretation, in the UK it’s grim and the Bank of England is stumped.
Investment Manager, Jupiter Independent Funds/Merlin
Investment Manager & ESG Investment Director, Independent Funds/Merlin
US inflation: something for everyone
This week’s US inflation data offered red meat to both sides of the US inflation argument. Falling nearly a full percentage point from 4.9% in April and continuing its unbroken trend of month-on-month declines over 12 months (peak CPI was 9.1% mid-way through 2022), the headline CPI figure of 4.0% in May demonstrated that reaching the Fed’s 2% target is a realistic prospect in the foreseeable future. On the other hand, the Fed’s mandate specifically focuses on ‘core’ inflation (which excludes volatile food and fuel prices), and for those who say there is a deeper-seated problem with inflation becoming embedded, the core rate has been stuck stubbornly in a narrow band of between 6.0% and 5.3% since last November.
Fed fangle: squaring the circle of conflicting inflation and labour market mandates
The Federal Reserve hedged its bets, holding interest rates at 5.25% as most had expected. However, Chairman Jerome Powell reopened the door to the possibility of future rate rises should core inflation continue to be sticky at a level that is more than double the mandated target. The conundrum is that the Fed operates under a dual mandate: one is to maintain price stability with a “core inflation rate that averages 2% over time” (to which the obvious question is how long qualifies as “over time”; how long is a piece of string?); the other is to maintain maximum employment, here defined as “the highest level of employment that the economy can sustain over time” (see? There’s that indefinable period “over time” popping up again). Is maintaining maximum employment, one which explicitly “fosters as strong a labour market as possible for the benefit of all Americans” compatible with trying to return core inflation to 2%?
Powell clearly finds himself in a jam here. His post-policy meeting press conference revealed his quandary. If not of the rabbit-in-the-headlights disposition of his counterpart at the Bank of England, nevertheless his lack of surefootedness was revealing. On the one hand, he knows that much of the reason that the jobs market is tight is because the economy is proving remarkably resilient (some might say unresponsive) to the big surge in interest rates over the past 15 months Indeed in Q1 of this year, it accelerated to 1.6% year-on-year from 0.9% in Q4 2022. This relatively buoyant economy is still creating jobs where there are insufficient numbers to fill the capacity. On the other hand, to bring labour inflation rates down requires in his own words “loosening the jobs market”, that is to say manufacturing economic contraction and actively putting people out of work. However uncomfortably that sits with his mandate of maintaining a strong labour force, his inclination is to try and draw the steam out of wages but without crashing the economy in the process.
Time will tell whether this approach works or not. The policy hawks maintain that a short, sharp shock with aggressive tightening through both ramping up interest rates and constraining market liquidity would allow the economy and core inflation quickly to be re-set. The doves point to the risks of over-tightening and inflicting significant long-term economic damage which might take years to recover from. But it is important not simply to look at monetary policy as a stand-alone pillar of the economy; its counterpart, government fiscal policy, continues almost as though in a different dimension. Whatever the minor constraints applied recently in the debt ceiling row, it is the natural political inclination of Joe Biden and Janet Yellen his Treasury Secretary (and Powell’s predecessor at the Fed) to spend, spend, spend. It is a policy which is certainly making it no easier to moderate growth and jobs and to bring core inflation back to target.
The net effect of Powell’s meandering narrative on monetary policy over the past few months, and his latest nuance, is that investors have had to re-think the outlook for US interest rates. Having been fed the line that further tightening is a possibility, US government funding rates as measured through Treasury bond yields have maintained their upward pressure. By definition, the peak interest rate (known in the jargon as the ‘terminal rate’) has to be closer than a year ago when the rate rising cycle was in its infancy. However, we have seen many a false summit along the way. The one thing you learn in such times is that making hard-and-fast predictions about outcomes when you have little direct control over the inputs is tantamount to a mug’s game (and why we on the Jupiter Merlin team prefer to keep an open mind and react if/when the facts change).
Powell clearly finds himself in a jam here. His post-policy meeting press conference revealed his quandary. If not of the rabbit-in-the-headlights disposition of his counterpart at the Bank of England, nevertheless his lack of surefootedness was revealing. On the one hand, he knows that much of the reason that the jobs market is tight is because the economy is proving remarkably resilient (some might say unresponsive) to the big surge in interest rates over the past 15 months Indeed in Q1 of this year, it accelerated to 1.6% year-on-year from 0.9% in Q4 2022. This relatively buoyant economy is still creating jobs where there are insufficient numbers to fill the capacity. On the other hand, to bring labour inflation rates down requires in his own words “loosening the jobs market”, that is to say manufacturing economic contraction and actively putting people out of work. However uncomfortably that sits with his mandate of maintaining a strong labour force, his inclination is to try and draw the steam out of wages but without crashing the economy in the process.
Time will tell whether this approach works or not. The policy hawks maintain that a short, sharp shock with aggressive tightening through both ramping up interest rates and constraining market liquidity would allow the economy and core inflation quickly to be re-set. The doves point to the risks of over-tightening and inflicting significant long-term economic damage which might take years to recover from. But it is important not simply to look at monetary policy as a stand-alone pillar of the economy; its counterpart, government fiscal policy, continues almost as though in a different dimension. Whatever the minor constraints applied recently in the debt ceiling row, it is the natural political inclination of Joe Biden and Janet Yellen his Treasury Secretary (and Powell’s predecessor at the Fed) to spend, spend, spend. It is a policy which is certainly making it no easier to moderate growth and jobs and to bring core inflation back to target.
The net effect of Powell’s meandering narrative on monetary policy over the past few months, and his latest nuance, is that investors have had to re-think the outlook for US interest rates. Having been fed the line that further tightening is a possibility, US government funding rates as measured through Treasury bond yields have maintained their upward pressure. By definition, the peak interest rate (known in the jargon as the ‘terminal rate’) has to be closer than a year ago when the rate rising cycle was in its infancy. However, we have seen many a false summit along the way. The one thing you learn in such times is that making hard-and-fast predictions about outcomes when you have little direct control over the inputs is tantamount to a mug’s game (and why we on the Jupiter Merlin team prefer to keep an open mind and react if/when the facts change).
UK private sector wage inflation 7.6% and rising
If the US position is equivocal, the situation in the UK is the opposite. Private sector wage inflation is now tipping the scales at 7.6%; but even at that rate, real wages are still being eroded given the current headline rate of inflation of 8.7%. If CPI is slowing markedly across the major western economies, ours is proving stubbornly resistant at uncomfortably elevated levels. While the Fed has paused its policy tightening, even if temporarily, that is not a luxury afforded to the Bank of England when it reviews interest rates on 22 June. Andrew Bailey still appears stumped at the tightness of the UK jobs market, and in particular he seems bewildered by the significant proportion of the over-50s cohort who should still be economically productive but who have voluntarily absented themselves from the workforce since the pandemic. We have discussed in detail over the past few issues of these columns why UK government bond yields have been going relentlessly higher. This week’s wages data only added to the pressure, taking the sensitive 2-year Gilt to a yield of 4.9%. That was even above the peak rate seen at the height of the autumn Kwarteng budget car-crash, albeit this time without the added excitement of the Liability Driven Investments (derivative hedges employed by the pensions industry to protect against volatile bond prices) market melting in the process.
Jeremy Hunt, carts and horses
As the Tory party reverts to its comfort zone of political infighting and naked factionalism (once more with its fractured and tortured relationship with Boris as the focal point), it is clear the government is in a flap. Facing a brace and possibly three unforced by-elections and with a racing chance of losing all of them, clutching at straws, Chancellor Jeremy Hunt has declared that he is suddenly all in favour of tax cuts at the earliest opportunity. A Damascene conversion to Trussnomics, perhaps?
That seems very unlikely! We have long argued in these columns that reducing the rate of tax is demonstrably a Good Thing: empirical evidence shows that over time lower personal and business tax rates increase the nominal tax collected as they stimulate reinvestment in economic growth. We are not about to start arguing against that now. But the government needs to be serious about coherent economic strategy rather than merely throwing the electorate a bung with lower taxes. A prerequisite of reducing the tax burden and allowing sustainable, self-supporting economic growth, is fundamental reform of public sector spending.
The Office of Budget Responsibility’s latest estimates for the fiscal year 2023/4 show total government spending of £1.19 trillion, 46.2% of GDP. Almost exactly 40% of that is attributable to the aggregate expenditure on health & social care (£176.2bn), Universal Credit (£83.0bn), state pensions (£124.3bn) and ‘other’ welfare of £87.2bn. Included in welfare is around £24bn of disability payments to people of working age. Weighing in at a sum even bigger than Universal Credit is the upwardly revised interest charge on UK government debt: at an estimated £94bn (8% of all government expenditure) it is now £10bn higher than the previous estimate of only a few months ago and more than double the annual pre-pandemic cost.
Clearly there is a political expediency in putting clear blue water between Labour and the Conservatives when it comes to economic policy, especially with the Tories stuck 15 points adrift of Labour in today’s polls. But economic common sense says that the logical order in which to proceed is first to reform public services (as distinct from simply cutting expenditure; reform and cost cutting are most definitely not the same) to put them on a sound footing, to make them sustainable and capable of delivering incremental benefit at lower cost; having ensured that reform is embedded, then one can begin comprehensively cutting tax rates and offering incentives for private sector investment to deliver a match-fit economy capable of enduring growth. Self-sustaining growth without constantly having to rely on the Bank of England to grease the wheels through quantitative easing (i.e. adding yet more debt) must be the target (the evidence from 6 years of constant QE in the eurozone was that far from having a multiplying effect on the economy, as time went on, every successive euro’s worth of QE increasingly obeyed the law of diminishing returns tending towards zero benefit). But as we know only too well, public sector reform requires significant political bravery and determination to see it through, as well as a decent majority in parliament and the full support of your own MPs to have any chance of success of implementing it in the first place.
The risk of doing it in reverse, putting the cart before the horse for purely political purposes, is that the economy continues to haemorrhage cash, driving up the nominal debt even further with all its associated costs. The likely reaction of the bond markets taking a dim view is not difficult to predict. The problem is that the Tories are rapidly running out of time, faced with a hard deadline with the electorate in a maximum 18 months’ time. After 13 years in office, it’s a bit late!
The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.
That seems very unlikely! We have long argued in these columns that reducing the rate of tax is demonstrably a Good Thing: empirical evidence shows that over time lower personal and business tax rates increase the nominal tax collected as they stimulate reinvestment in economic growth. We are not about to start arguing against that now. But the government needs to be serious about coherent economic strategy rather than merely throwing the electorate a bung with lower taxes. A prerequisite of reducing the tax burden and allowing sustainable, self-supporting economic growth, is fundamental reform of public sector spending.
The Office of Budget Responsibility’s latest estimates for the fiscal year 2023/4 show total government spending of £1.19 trillion, 46.2% of GDP. Almost exactly 40% of that is attributable to the aggregate expenditure on health & social care (£176.2bn), Universal Credit (£83.0bn), state pensions (£124.3bn) and ‘other’ welfare of £87.2bn. Included in welfare is around £24bn of disability payments to people of working age. Weighing in at a sum even bigger than Universal Credit is the upwardly revised interest charge on UK government debt: at an estimated £94bn (8% of all government expenditure) it is now £10bn higher than the previous estimate of only a few months ago and more than double the annual pre-pandemic cost.
Clearly there is a political expediency in putting clear blue water between Labour and the Conservatives when it comes to economic policy, especially with the Tories stuck 15 points adrift of Labour in today’s polls. But economic common sense says that the logical order in which to proceed is first to reform public services (as distinct from simply cutting expenditure; reform and cost cutting are most definitely not the same) to put them on a sound footing, to make them sustainable and capable of delivering incremental benefit at lower cost; having ensured that reform is embedded, then one can begin comprehensively cutting tax rates and offering incentives for private sector investment to deliver a match-fit economy capable of enduring growth. Self-sustaining growth without constantly having to rely on the Bank of England to grease the wheels through quantitative easing (i.e. adding yet more debt) must be the target (the evidence from 6 years of constant QE in the eurozone was that far from having a multiplying effect on the economy, as time went on, every successive euro’s worth of QE increasingly obeyed the law of diminishing returns tending towards zero benefit). But as we know only too well, public sector reform requires significant political bravery and determination to see it through, as well as a decent majority in parliament and the full support of your own MPs to have any chance of success of implementing it in the first place.
The risk of doing it in reverse, putting the cart before the horse for purely political purposes, is that the economy continues to haemorrhage cash, driving up the nominal debt even further with all its associated costs. The likely reaction of the bond markets taking a dim view is not difficult to predict. The problem is that the Tories are rapidly running out of time, faced with a hard deadline with the electorate in a maximum 18 months’ time. After 13 years in office, it’s a bit late!
The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.
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