Glint Special Report: Inflation and Interest Rates

The US Federal Reserve pushed its benchmark funds (base) interest rates up this week, by 0.75%, to a range of 3.75%-4%, in an entirely expected move. The Bank of England (BoE) followed suit two days later, raising the UK’s base rate to 3%, the “highest in 33 years” shouted the Twittersphere.

The two central banks appear to be in lockstep but there may be a parting of the ways from here on. While the underlying economic picture in the US still seems relatively strong, the UK stumbles closer towards a recession.

The US had a huge increase in job vacancies (seen as a proxy for labour demand) in September, with total openings at 10.7 million by the end of the month. Firms are competing to find unskilled or semi-skilled employees; wages in the 12 months up to September 2022 rose by 5%. In September wages in the US on average rose by 8.2% year-on-year. This kind of data makes the Fed’s anti-inflation drive complicated. In September, the US core consumer price index (CPI) – which excludes food and energy – rose by an annualized 6.6%, the highest since 1982. Do these figures reflect the inflation experience of consumers and businesses? After all, between May 2020 and June 2022 energy prices in the US have gone up by an astonishing 85%.

The Fed’s chairman, Jerome Powell, is desperately keen to stop raising interest rates, which obviously put up costs of borrowing across the economy and might topple economic growth. Many investors are speculating (hoping?) that at its next meeting in December the Federal Open Market Committee (FOMC), the body which sets rates, will signal that rate rises are slowing, and will put rates up then by 0.50%. The question for most investors is – what will the ‘terminal’ rate (i.e. end point) be? Will it be 4%, or might it be even higher? The Fed’s target is to achieve annual inflation of 2%. At the moment that seems very remote – so interest rates will continue to rise, the Dollar will strengthen further, and those holding debts in Dollars will find their costs rising. Meanwhile banks and other lenders, eager to take advantage of the central bank’s help for their profit margins, will put up their rates to borrowers with alacrity, but their rates to lenders more slowly. Powell said the Fed aims to “moderate demand so that it comes into better alignment with supply”. His hope for a Goldilocks outcome – neither too hot nor too cool – looks remote right now. The Financial Times put the outlook like this:

• “hike until something breaks
• try to fix whatever broke by cutting rates”

A Goldilocks outcome is just a distant dream for the UK, according to the latest reading from the BoE. It said the UK is facing its longest recession since the Great Depression (which lasted between 1929 and 1932). Inflation in the UK hit 10.1% in September and the Bank expects it to peak at 11%. The Bank said we should expect more interest rate hikes, in the hope of bringing inflation back to its target of 2%.

Christine Lagarde, president of the European Central Bank, voiced the fears of many when she said this week that a “mild recession” in the Eurozone (and elsewhere, maybe?) will not be enough to “tame inflation”.

An obvious, if tactless, question arises. Do the central bankers who are responsible in various guises for price stability have any real idea what they are doing? They have only a limited set of tools to manage the rise and fall of prices. When inflation threatens to get out of hand they raise interest rates; when an economic downturn threatens they cut interest rates.

The last time inflation was a threat was in the 1970s. Prices started climbing in the 1960s when the US funded its war in Vietnam. Then came the oil price shock. Sounds familiar. Inflation shot up to more than 20%/year. A previous Fed chairman, Paul Volcker, raised interest rates to 20% and eventually inflation fell to slightly more than 3% in 1983. But the pain was severe; almost four million lost their jobs in back-to-back recessions in the 1980s.

Given that we are now around half-way to that shocking inflation point, we ought probably to have higher interest rates – except that general elections in both the US and the UK are at most a couple of years away, and a recession is no vote-winner. Markets are febrile right now. People sense that they are strung between two unpleasant poles – rampant inflation, higher mortgage rates, poor returns on the obvious investments, or lower prices but at the cost of job losses and consequent hardship.

But maybe some central bankers are being cannier. According to the latest report from the World Gold Council (WGC) central banks bought almost 400 tonnes of gold in the third quarter of this year, four times more year-on-year. The total such buying this year is the biggest since 1967, when the Dollar was still backed by gold. Turkey, where inflation has just reached 85.51%, is the biggest reported buyer of gold so far this year, adding 31 tonnes in the third quarter, 95 tonnes since the start of 2022, bringing its total gold reserve to 489 tonnes.