The Fed factor

A good week for

• The US dollar gained on a trade weighted basis following an interest rise from the Fed
• Japanese equities rose in sterling terms, despite declining in local currency terms

A bad week for

• Sterling weakened against main currency pairs
• Bonds and Equities fell in local currency terms across all major regions

US monetary policy

The US Federal Reserve increased interest rates by 0.75% this week as widely expected. It was the third hike in a row and takes the Fed Funds rate to 3-3.25% from 0% in March. The Fed hasn’t moved so aggressively for decades. FOMC members were in unilateral agreement: they have made it clear that they will attempt to tame inflation almost at any cost. They also now anticipate the Fed rate to reach ~4.4% by the end of the year, implying another 0.75% rise followed by 0.5%. Higher unemployment of around 4.4% and slower growth will likely result, they said. However, at 2.3% core inflation, which excludes volatile food and energy, is still forecast to be higher by 2024 than the Fed’s 2% target, suggesting more needs to be done. Another consequence of US rate rises is dollar strength: year-to-date it’s appreciated by ~30% against the yen and 18% against the pound.

UK monetary policy

The Bank of England followed suit with a smaller 0.5% rise in interest rates, but disagreement amongst Monetary Policy Committee members led to a split vote, with preferences ranging from 0.25% to 0.75%. A tight labour market and stubbornly high inflation supported the rise but the impact of the government’s Energy Price Guarantee is still uncertain. The intervention should limit the destruction of real incomes and support discretionary spending - although household energy bills will still jump by an average of 27% in October. Continued spending could prolong higher inflation with risks to higher-for-longer inflation in the medium-term. Another conundrum is labour market participation. It remains stubbornly low and is compounding a tight jobs market,  giving workers more bargaining power. Overall, a case could be made for accelerating further rate rises. We may have to wait for more data in November to know.

UK fiscal policy

The UK government announced a number of tax cuts on Friday, in addition to help with domestic and commercial energy bills. The Treasury cancelled the Health and Social Care levy as of November, and increased the stamp duty threshold to £250,000, and £425,000 for first-time buyers. From next April, basic rate income tax will be cut to 19%, and the 45% additional income tax rate will be abolished except in Scotland. Plans to raise corporation tax to 25% have also been cancelled, along with the rise in alcohol duty. In total, the tax measures are likely to equal £26.7bn of spending in the coming fiscal year, in addition to the c. £150bn over two years previously announced to subsidise energy bills. Energy relief is likely to have the biggest impact on the economy, lowering near-term inflation and the hit to real incomes and growth. The net impact of other measures cannot be fully assessed until the Autumn Budget, as the Chancellor may announce spending cuts in order to lower the borrowing impact.

UK government borrowing

August’s UK public borrowing figures revealed that net borrowing was ahead of forecasts, with new measures expected to push it higher. Public sector net borrowing excluding public sector banks was £11.8bn in August, above the OBR’s forecast of £6bn. This was primarily due to a surge in debt interest payments, pushed up by high inflation, impacting index-linked bonds, and a higher policy interest rate. New measures announced this week are likely to push public borrowing higher, though the total impact will depend on how the Treasury chooses to structure the support.

Japan monetary policy

The Bank of Japan (BoJ) left monetary policy unchanged at last week’s meeting but did announce currency interventions. At a time when most central bankers are facing high inflation and tightening interest rates, Japanese inflation is expected to fall back below 2% early next year and the Bank remains in easing mode. At the September meeting, the BoJ opted to extend pandemic-era liquidity measures until March 2023, with further easing on the table, and Governor Kuroda indicated that policy was likely to remain easy for several years. The widening gap between the Bank of Japan’s monetary policy stance and other central banks, including the US Fed, has led to a dramatic depreciation in the yen, down c. 13% year-to-date. Following yesterday’s announcement, BoJ officials intervened in currency markets to support the yen, however, without a change in monetary policy this does not look sustainable.

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