Stephen Miller

BoE intervention is not sustainable

In Kris Kristofferson’s famous ballad Sunday Morning Coming Down (of course, popularised by the late Johnny Cash) the protagonist speaks of one Sunday morning, after a particularly heavy Saturday night, of having “fumbled through my closet for my clothes and found my cleanest dirty shirt”.

It is a metaphor for central banking in 2022 as after a period of egregious excess (the application of historically high levels of monetary stimulus for too long), central banks are now looking for “least-worst” outcomes – the “cleanest dirty shirt”.

The “cleanest dirty shirt” approach is the path taken by those central banks (The Federal Reserve (The Fed), The Bank of Canada, the Reserve Bank of New Zealand (RBNZ), and more arguably the Reserve Bank of Australia (RBA)) who learned (admittedly late in the piece) the lessons from ‘70s style inflation. In other words, that any further delay in articulating a coherent and firm response to an inflation threat only heightens the risks of more substantial macroeconomic dislocation down the track.

Other central banks like the European Central Bank (ECB) and the Bank of England (BoE) in particular, have defaulted to a “dirtier dirty shirt” approach.

Like nearly every other developed country central bank, the BoE was tardy in recognising just how great a challenge inflation would prove for monetary policy. However, in my view not only was it lax in recognising the problem, but it has also been laxer than others in attempting to rectify the consequences of its earlier policy missteps. At stages, BoE’s Governor Bailey appeared to question whether the BoE had a frontline role to play in tackling inflation.

The BoE’s decision to intervene in bond markets overnight, while temporarily sending bond yields sharply lower, is not sustainable. The measure was enacted for “financial stability” purposes associated with liability driven investment (LDI) pension fund schemes. Indeed, the BoE may not have had any other accessible option, reflecting the policy mess in which the UK is mired. However, any sustained bond is not an option as it will only fuel an inflation conflagration. At face value the BoE intervention is an easing of monetary policy that follows on a substantial easing of fiscal policy which will simply fuel inflation at a time when it has already reached a 40 year high. Sustaining the intervention will visit on the UK a policy mix that resembles the worst excesses of monetary financed fiscal deficits redolent of banana republic economics of the 1970s.

That policy mix will send the Great British Pound (GBP) even lower.

The benign outcome is one where the turmoil in markets subsides in the face of the temporary BoE intervention. That is not implausible but is also unlikely. The UK and the BoE face daunting and deeply rooted fundamental economic challenges.

The European Central Bank (ECB) is structurally cursed with an institutional inertia in its decision-making which too often leads to lowest-common-denominator outcomes. It took until June of 2022 when it finally retired the last vestiges of “emergency” monetary stimulus measures.

The BoE (at least until last night) and the ECB have belatedly upped the ante on inflation but still face challenges.

Putting aside the issues with LDI pension schemes, the BoE has the added complication of what looks like a mismanagement of the Brexit process which at the margin has exacerbated supply chain and labour shortage issues. More importantly, it now has to confront the fact that the Government’s fiscal policies are pushing in a different (inflationary) direction. UK fiscal policy has roiled bond and currency markets to the extent that markets are now demanding an aggressive BoE response to temper inflation and bond market and currency market turmoil.

The ECB also has a uniquely delicate task. Like the BoE the delicacy of that task follows partially from being tardier than most in seeking to contain inflation. Worryingly, there is also the issue of the impact of rising borrowing costs on heavily indebted member states (so-called “fragmentation”). Policy rate increments of 75 basis points will need to be accompanied by credibly articulated “anti-fragmentation” measures designed to protect the debt servicing capacities of the Eurozone’s most vulnerable members, most notably Italy.

However, not an easy task to conceive of a construct that would satisfy existing legal requirements under which the ECB buys / sells bonds of its various members in proportion to their capital contributions to the central bank. At a minimum, a departure from that principle would be an anathema to the more frugal Northern European members, involving as it does an implicit fiscal transfer from the North to the South.

In this sense, the ECB appears to have been visited (or visited upon itself) a fundamental incompatibility between the twin tasks of raising (“normalising”) borrowing costs to combat inflation, while at the same time also keeping a lid on borrowing costs for the bloc’s most indebted members. This at a time when Italy’s political circumstance is highly fragile. The most pessimistic scenario is European Debt Crisis 2.0.

The Fed continues to (appropriately in my view) take an aggressive stance. Measures of the ‘underlying’ inflation pulse continue to show extraordinary momentum with no meaningful evidence of retreat from historically high levels. On a 3-month annualised basis, the Cleveland Fed measure of median and trimmed-mean inflation are running at 8.3 per cent and 7.7 per cent respectively.

But the Fed doesn’t have the extraneous worries like those confronting the ECB and the BoE.

The latest Fed “dot plot” shows the median expectation for the policy (Fed Funds) rate by year-end is 4.4 per cent. With two meetings left that would most likely imply a 75 basis point / 50 basis point sequencing for the two remaining meetings. But the Fed’s “cleanest dirty shirt” approach and the relative absence of extraneous complications gives it greater flexibility in managing the process should recession fears escalate.

Aggressive monetary policy probably means the continuation of the recent trend towards higher bond yields, lower equity markets and a higher US dollar (USD). However, the intensity of bond and equity moves in US markets may diminish into year-end. This is probably true of others as well such as Canada, New Zealand and maybe even Australia.

The USD remains the “cleanest dirty shirt” among currencies.

The US may or may not endure a recession but it is better placed than Europe and the UK to attain a “second or third best” outcome.

Europe and the UK are increasingly looking at “nth best outcomes”. European and UK markets look to be in for a wild ride on all fronts.

RBA Board Meeting on Tuesday: Board considered a downshift to 25 basis points in September

In my view “sticky” domestic inflation suggests imminent step-down in policy rate increment premature.

A little surprisingly in my view were the minutes from the RBA September Board meeting which indicated that the Board considered a downshift to a 25 basis point increment even if ultimately eschewing that path.

That noted, it is clear that the RBA Board wishes to give itself maximum optionality when it comes to determining the size and timing of future policy rate increases and that incoming data will be the most important determinant of the future policy rate trajectory. Hence the maintenance of carefully worded counsel that it was “not on a pre-set path” when it came to future policy rate increments.

Given the current elevated level of uncertainty that attaches to both the domestic and global economic outlooks, that seems entirely appropriate.

Of course, that is not necessarily inconsistent with a step-down in monthly policy rate increases but nor does it any way make that eventuality any nearer.

After last year’s ill-fated guidance that the conditions for a policy rate increase “will not be met before 2024,” the last thing the Board needs to do now is to appear to pre-commit to a policy path that is subject to the aforementioned uncertainty.

Some commentators have warned that given the lags in monetary policy, there is a risk that the RBA may overdo it and plunge the economy into recession. However, while housing is retreating from the frenetic price and activity action that followed on from massive (and excessive) monetary stimulus, the labour market and the consumer (judging from yesterday’s August retail sales release) have been reasonably resilient.

Still, it must be acknowledged that recession is a risk.

But so is a premature declaration of victory over the inflation threat.

It might be that too soon a reduction in the policy rate increment also runs the risk of letting the inflation genie run amok.

On that front, high frequency price and wage data continues to exhibit extraordinary momentum.

That what the Governor has described as the “scourge” of inflation is a clear and present danger.

The most recent NAB Monthly Business Survey for August continued to exhibit troubling inflation portents for the September quarter and beyond.

Final product retail prices in the August survey increased at a quarterly rate of 3.3 per cent, the same record rate as was recorded in July.

Such momentum indicates a danger of the emergence of the sort of inflation inertia that was last experienced on a global scale in the late ‘70s / early ‘80s, and which lasted a little longer in Australia.)

Moreover, it is suggestive of some upside risk to the most recent RBA trimmed-mean inflation forecast, issued just over a month ago, of a 6 per cent increase over the year to the December quarter 2022.

The policy rate in Australia is relatively low compared to “dollar bloc” peers. Inflation may be also but that is less certain given momentum in high-frequency domestic price data.

In this context I remain of the view that any pivot to the lower 25 basis point increment in October would be premature and that prudence dictates that a further 50 basis point increment is the more appropriate course.

I expect the RBA has a similar view.

Coming up: Eurozone provisional September CPI; US August PCE price index

Provisional Consumer Price Index (CPI) data for September will be released on Friday night. This follows the release of German and Spanish numbers on Thursday night. These numbers are only likely to underscore the challenges ahead for the ECB, as mentioned earlier.

August data for the Fed’s favoured inflation measure, the “core” Personal Consumption Expenditures (PCE) price index is released on Friday night. Key market moves occurred in the wake of the “shock” August CPI figures released earlier in the month and it would take a number significantly away from expectations to elicit any meaningful market reaction. That seems unlikely.

By Stephen Miller, investment strategist 

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