In what could become be a dry run for the Federal Reserve in the very near future, this month’s inflation report by the Bank of England revealed the growing likelihood that rates in the UK are likely to remain unchanged for the foreseeable future due to the worldwide collapse in commodity prices and a strong value of sterling versus the rest of its major trading peers. Similar to the US market, a rate hike sometime this year was heavily baked into investors assumptions for the UK economy, and these latest minutes are sure to throw the market off guard with regards to both the BoE and Fed’s rate tightening schedule.
Commodity Driven Deflation begins to Accelerate
The BoE’s dovish comments come on the back of slowing inflation in June, with CPI in the UK falling back to 0% on a month over month basis. The BoE’s monetary policy has an inflation targeting policy of 2% as part of its commitment to helping sustain a growing economy and employment picture. In his open letter to the UK chancellor, BoE Governor Mark Carney identified an unusually low contribution from energy and food prices as being the main trigger for the sluggish inflation figures. Carney’s comments reflect the growing reality for the US and UK that the ongoing commodity rout, and relative strength in both nations’ currencies are triggering a return to the deflationary environment which existed in the first quarter of this year.
Carney hinted that the slowing commodity market could lead to a slowdown to global growth, although he maintained the bank’s forecast that growth in advanced economies would accelerate (this seems dubious). In his own words:
“The Committee projects UK-weighted world demand to expand at a moderate pace. Growth in advanced economies is expected to be a touch faster, and growth in emerging economies a little slower, than in the past few years. The support to UK exports from steady global demand growth is expected to be counterbalanced, however, by the effect of the past appreciation of sterling. Risks to global growth are judged to be skewed moderately to the downside reflecting, for example, risks to activity in the euro area and China.”
The Fed looks increasingly likely to follow the BoE cautionary stance
Carney’s comments are likely to increase doubt over the Fed’s ability to raise rates in the coming months. Both the Fed and the BoE are cut from the same cloth, and their similar modelling techniques should result in the same deflationary headwinds beginning to appear in official data in the weeks and months ahead. The Fed is facing an increasingly difficult decision, especially given the backdrop of official economic data coming out of the US which paints a narrative of improving employment within the economy. If the Fed continues to stick to its mantra of being data dependent, then it will risk triggering massive capital flight across world markets as the USD carry trade unwinds in earnest. The Fed will be very well aware of this scenario, and it is for this reason that we are likely to see a more cautionary stance develop amongst the Fed in the weeks ahead. We are already starting to see GDP forecasts come in well short of expectation, with the Atlanta fed predicting a mere 1% increase in GDP in the third quarter, nearly 2% lower than consensus wall street expectations! The Atlanta Fed has been highly accurate with its GDP forecasting this year, so if the trend continues, the outlook for GDP downgrades in the months ahead looks a certainty. The collapse in the shale oil and gas sector alone is likely to see a formidable reduction in capex in the seconf half of 2015 – none of which has been priced into wall street analysts’ expectations. Faced with deflation, a strong US dollar, and deteriorating GDP growth, who would seriously bet on the Fed raising rates in the near future? The funny thing is – the market still is! The likelihood is that we are going to see a very sharp realization that the interest rate expectations for this year are way off the mark. How this realization happens without a complete breakdown in credibility of central banks’s is a discussion for another day, but it seems increasingly likely that if trends around the world continue as they have been in the first half of 2015, we are far more likely to see references to QE4 in mainstream financial press in the very near future.
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