The pound has tanked over the last few days, hitting its lowest level against the US dollar since September 2020 (by the time you read this, it might be more like July 2020).
Markets are suddenly more worried about recession than they are about rocketing inflation.
If it’s any consolation, this isn’t just a UK problem. However, the UK does seem to be a bit ahead of the pack.
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The Bank of England is caught between a rock and a hard place
Inflation remains high in the UK and it’s almost certain to rise again when figures for April come out next month.
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Usually this would imply significantly higher interest rates. The Bank of England’s job is to keep inflation running between 1% and 3%, with the closer to 2% the better. And for a brief moment, that’s what everyone thought would happen.
But now markets are thinking better of it. They don’t think the Bank of England will be able to raise interest rates because we’ve just had some woeful economic data.
UK retail sales for March were awful, dropping by 1.4% compared to the previous month, a much worse figure than expected. Meanwhile, consumer confidence has tumbled. It’s close to its lowest level since records began (and that data goes back almost 50 years, so it’s pretty awful).
As a result of this grim data, markets are now much less convinced that the Bank of England will raise interest rates by anything like as much as they’d thought.
In turn, the pound has slid heavily – particularly against the US dollar, which is still being propped up by investors who expect the Federal Reserve to be pretty aggressive with rate hikes this year.
Of course, this still means you have an inflation problem. On that point, you might well argue: “But what can – or even should – the Bank of England do to offset soaring energy prices? After all, aren’t they just a tax on consumers?” And you would be right.
That said, my retort would be to point out that in the 1990s and early 2000s some of us were saying: “But what can – or even should – the Bank of England do to offset rampant disinflation caused by China joining the global capitalist community? Don’t collapsing consumer goods prices represent a demand stimulus to which it is unnecessary to add far cheaper credit and thus rip-roaring house prices on top?”
In short, I’m sure that the Bank of England realises that not every problem is a nail. However, it has been given naught but a hammer to wield against said problem.
Interest rates are a blunt instrument, and maybe inflation targeting should adjust to underlying secular conditions rather than be set at one level the whole time. But it’s kind of late in the day to be having this revelation.
Can anything save the UK from recession?
Anyway, let’s park that little philosophical difference and get back to the real world of money.
Investors are right to be worried. The UK is a consumer-led economy and consumers are under a great deal of pressure. For most of us, electricity is not an optional extra. In my experience, people are pretty parsimonious with their energy bills, so I can’t imagine that there’s a lot of slack in the system.
The more you have to spend on “needs”, the less you have to spend on “wants”.
So are we looking at a recession?
The odds are rising, there is no sense in pretending otherwise. That said, we still have a few factors on the other side that might help.
If consumers are feeling the squeeze, they either need to cut back or get extra money from somewhere. There are a few sources of the latter.
One, employers. The labour market remains tight. There’s still a lot of talk of employers having to push up wages to hire. If we start to see “real” (after-inflation) wage increases, that would be good news (not necessarily for shareholders as they have to pay for it, but it’s certainly the best way to avoid recession).
Two, savings. There are still plenty of savings built up in aggregate. The tricky thing is that those are unevenly distributed. So the same people who are feeling the pain from prices rises most are probably not the same people who have the savings.
Three, credit. Consumers are not over-borrowed relative to history, so there’s room for them to borrow more money to maintain their standards of living.
The last two factors are short-term solutions; the longer-term issue is really about whether the cost of living squeeze eases up at all.
I can see a scenario in which commodity prices peak and start to ease off (China’s current woes with stop-start coronavirus shutdowns are likely to hit commodity prices in the short term), but it’s harder to see why inflationary pressures will disappear altogether.
What might be possible is that we see bond yields hit a short-to-medium term top as energy prices peak for now, and central banks pull back from tightening any further.
If that happens, some of the concern consumers feel about inflation coinciding with rising mortgage rates might drop away, and if we can get ongoing strength in the labour market as well, the ideal scenario of wages rising in “real” terms might come about.
But it’s going to be touch and go, I feel. We’ll keep you up to date – if you haven’t yet subscribed to MoneyWeek magazine, I suggest you do so now and get your first six issues free.
