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Interest rate normalisation unlikely to return

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Interest rates have firmed up, as the debt market took into account the latest action from the ECB and prepared itself for the results of this week’s meetings of the FOMC and MPC.

The ECB’s action of cutting the monthly amount to be purchased under its QE programme from €80bn to €60bn but extending the commitment period to the end of the year, rather than the six months to end of September as expected, generated a degree of confusion. The reduction in the purchase amount was initially taken as the start of a tapering of the QE programme. However, Mario Draghi pointed out that the additional extension of the QE programme committed the ECB to a greater total amount of purchases overall. While saying it should not be taken as any reduction in its support for the underlying economic recovery, he did recognise that the risk of deflation had largely disappeared.

In truth it was the Italian referendum and its aftermath that concentrated most minds in Europe last week – and it continues to do so. Paolo Gentolini, previously the Foreign Minister, was promoted to Prime Minister. He inherits a pretty poisoned chalice, although it also seems to be a pretty practical choice as well. Almost everybody expects that elections will have to be held in the first half of next year when, having licked his wounds, Mario Renzi is likely to try and stage a comeback.
In the immediate future, Gentiloni has the Monte dei Paschi crisis to resolve. The ECB has given the bank until the end of the month to raise an additional €5bn of capital, and last week turned down its appeal for more time. Even if Monte dei Paschi managed to get a large rights issue off the ground it would probably be at the expense of defaulting on some of its junior debt. The other alternative - state control - would produce the same result. Unsurprisingly, although at very low levels generally, Italian sovereign debt had a bad time last week. Its 10 year government debt has moved up to yielding more than 0.50% more than the Spanish equivalent and more than double the yield available on 10 year Irish bonds.

Focus will shift back to the Anglo Saxon economies this week, with the Fed announcing the result of its deliberations on Wednesday evening. Few have many doubts left that the result will be an increase of 0.25% in the Fed’s repo rate. More anxiously awaited are the comments on the speed at which the Fed will pursue its process of returning to normalisation. Some are expecting this to come in the form of a further 0.25% rate hike each quarter throughout 2017. This would probably represent the most bearish forecast, but with President-elect Trump raising the prospect of a major economic stimulus, not many are willing to argue against a major retrenchment in the US bond market.

Not only will the MPC know what the Fed’s response is to an economy having to absorb greater inflationary pressures and low unemployment, it will be able to compare the UK’s situation with key statistics due to be released this week. Tomorrow will bring the latest inflation and producer price data. The targeted CPI inflation figure is expected to increase by 0.2% up to 1.1%. While this will be the highest that has been seen in two years, it has a good long way to go. The median expectation is that it will hit its target level by April next year and have blown all the way up to 3% around the turn of 2017. The latest producer price indices are also announced on Tuesday. The median forecast is that the annual increase in the input price index will remain at around a pretty scary 13.5%.

On Wednesday come the latest labour market figures. Unemployment, having fallen to 4.8% last month, is expected to remain unchanged as is the average earnings rate at 2.3%. On Thursday the latest retail sales figures will be released. Having been running at an almost maniacal rate, November’s result is expected to show an inevitable reaction. However, no economists appear to be predicting an outright fall, with the median forecast being of a small increase in volume of 0.2%. Even having allowed for this rather depressed figure, the annual rate will still be running at a remarkably strong 5.8%.

All this leaves the Bank of England’s MPC with something of a dilemma. The committee completely (if understandably) misjudged the strength of the economy in the aftermath of the referendum and produced the monetary easing package in August which was, with the benefit of hindsight, totally unnecessary. This week’s economic results combined with the example from the other side of the Atlantic are only likely to emphasise the corner in which it now finds itself. 

The MPC will, of course, argue that it needs to keep interest rates low, firstly as a precaution against Brexit’s potential to send economic growth into reverse. However the Brexit effect, according to its own forecasts, is likely to be much less severe than first predicted. Secondly, the MPC does not like increasing rates in response to inflationary pressures and is inclined to ‘look through’ them as being a temporary influence. This is a remarkably useful little platitude. As any influence on inflation, in either direction, is removed from the index after a year of inclusion, the whole index is by design, made up of temporary factors. The MPC might have some credibility on this front if they had looked through low inflation and raised rates, when the economy was strong, but inflation low, as in 2014.

The net result is that nothing is likely to emerge from this week’s MPC meeting as any rolling back of the August package would involve the tacit admission of an error. We might have got some retraction of the QE programme, had the Prime Minister not made clear her dislike of the structure. We would assume that the MPC would regard reacting to a political comment, however justified, as probably worse than admitting to an error of judgement





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