Where next for interest rates?

One of the oddest things about financial commentary is how quickly fashions and fads change. A year ago and until around April this year, all the talk by analysts was of a ‘Fed Pivot’ – how the US Federal Reserve was about to or should ‘pivot’ away from its policy of incremental interest rate rises, and start cutting them. To reverse its previous policy, in other words. This hope of a pivot always seemed premature, given that US inflation was stubbornly stuck in the high single digits. US inflation in 2022 was 8%; one consequence of this is that the purchasing power of the US Dollar dropped by 8% last year.

The Fed was slow to raise interest rates and has consistently been behind the curve. In March 2022 inflation was 8.5%; only in that month did the Fed start to raise rates aggressively, inching them up at 10 successive meetings. The federal funds rate is now 5%-5.25%, the highest level since 2007. These rate increases take time to work their way through the economy; it’s like steering a super-tanker. Interest rate rises are the sole (and rather clumsy) tool a central bank has to rein-in inflation; the aim of putting up interest rates is to make credit more expensive, take money out of circulation, force companies to tighten their belts – and ultimately cause job losses, and slow demand. A central bank is always walking a tightrope – too loose monetary policy can mean too much fiat currency gets into the system, bringing about inflation; too tight monetary policy can tip an economy into a recession.

At last week’s meeting of the Federal Open Market Committee (FOMC), the part of the Fed responsible to interest rate decisions, the choice was to halt rate rises for the time being. ‘Pivot’ metamorphosed into ‘pause’. A ‘hawkish’ pause, however. In the words of the president of the Chicago Fed, Austan Goolsbee, this pause is “reconnaissance mission... before charging up the hill another time. There are conflicting pieces of evidence coming in on the economy: are we too hot and need more, have we done enough by raising the interest rates five full percentage points over the last year?”

Higher for longer

Higher interest rates make the Dollar relatively attractive for investors, who want a return, or ‘yield’.  They also strengthen the Dollar. Dollar-denominated US government bonds (treasuries) are widely seen as risk-free. After the ‘pause’ on interest rate moves last week the yield on the two-year treasury note, which moves in line with policy expectations, rose by 0.1 percentage points to 4.77%; Jerome Powell, chairman of the Fed, dampened hopes of an early ‘pivot’. He said: “It will be appropriate to cut rates at such time as inflation is coming down really significantly….we’re talking about a couple of years out…not a single person on the committee [the FOMC] wrote down a rate cut this year, nor do I think it is at all likely to be appropriate.” The reason why the Fed will not cut interest rates is that it now expects ‘core’ inflation (which strips out energy and food price inflation), will still be 3.9% by the end of this year, declining to 2.6% in 2024 and 2.2% in 2025. So by the end of 2023 ‘core’ inflation will still be around twice the Fed’s target for inflation.

"not a single person on the committee [the FOMC] wrote down a rate cut this year, nor do I think it is at all likely to be appropriate.” Jerome Powell

No such pause is likely this week in the UK, when the Bank of England’s (BoE) Monetary Policy Committee (MPC) meets to decide interest rates. The UK’s inflation rate in May (the most recent figure) was 8.7%. As elsewhere, the removal of food price rises from official inflation figures has the effect of smoothing downwards the overall inflation figure. Olive oil in the UK for example has gone up in price almost 50% in the past year, and eggs almost 40%. The UK’s core inflation in May was 7.1%, 0.3% higher than the previous month.  Andrew Bailey, the governor of the BoE, said last week that inflation is “taking a lot longer” to come down than he hoped. The BoE, like the Fed, tries to maintain inflation at 2%/year. It now seems certain that the BoE will have to push interest rates much higher (they are currently 4.5%) to repress inflation. The expectation is that interest rates will need to rise above 5.5%, maybe as high as 6%. Such high rates will cause considerable pain for mortgage holders, many of whom this year are renewing their mortgages on a variable rate, as their fixed rate deals are coming to an end. Rates that high could tip the UK economy into a recession either late this year or early next.

Beware future surprises

Trying to discern where the global economy is headed is like peering into a cloud of fog; everything is too murky to be sure of what we are seeing. The Organisation for Economic Cooperation and Development (OECD) said in early June that global growth in gross domestic product (GDP) terms would slow to 2.7% this year (from 3.3% in 2022) and improve only moderately, to 2.9% in 2024. This forecast is well within the margin of error. Inflation levels are clearly very sticky in the UK and quite sticky in the US. One surprise that may make itself felt in the third quarter of this year is the global emergence of a deficit in crude oil supply. The price of Brent crude oil (an international benchmark) is just above $75/barrel right now, which Saudi Arabia, the world’s biggest producer, thinks is too low; various analysts see the price rising to $100/barrel later this year. Many other things, ranging from the cost of transport to the price of fertilizer, are related to the price of crude oil. The risks of an inflation ‘second wave’ - or perhaps of a continuation of the first wave - remain.

At Glint, we make every effort to demonstrate a balanced conversation between gold, crypto and fiat currencies when it comes to purchasing power and, while we strongly believe that gold is the fairest and most reliable currency on the planet, we need to point out that it isn’t 100% risk free. While we have seen a steady increase over time, the value of gold can fall, which means that its purchasing power can also decline.