New Fed chair Kevin Warsh takes the reins of the world's most powerful central bank at a difficult time, says Roger Ferguson for the Council on Foreign Relations think tank. Donald Trump wants easier money, saying, on swearing Warsh in, that “we want to stop inflation, but we don't want to stop greatness”. Trump openly criticised Jerome Powell, Kevin Warsh's predecessor, for failing to cut interest rates. But US inflation is running at 3.8% and has been above the Fed's 2% target for five years in a row. Cumulatively, the price level is nearly 25% higher now than it was in 2020.

Pricier petrol, the fallout of Trump's adventure in Iran, threatens to trigger a new inflation wave. Kevin Warsh may be “compelled to raise interest rates”, which is “precisely the opposite of what Trump had in mind”. Fireworks could lie ahead.

Kevin Warsh will have more elbow room when it comes to cutting the size of the Fed's balance sheet, says Colby Smith in The New York Times. He sees the institution's holdings of $6 trillion in government bonds and other securities as “emblematic of everything that has gone wrong” in central banking since the 2008 crisis. But drawing down the portfolio must be handled with great care. In 2019, a similar attempt to reduce the balance sheet too quickly gave markets a “near heart attack”.

Kevin Warsh must deal with ‘hot’ US inflation

Investors began the year expecting “at least one or two rate cuts”, says The Economist. Now, rate hikes are in the picture. US inflation is “hot”, and the cause is not just oil. Even the core measure, which excludes energy and food, rose at an annualised 3.2% during the three months to April. Central bankers are taught to “look through” energy shocks, which usually prove temporary, but broad-based signs of inflation are harder to ignore. Service prices are rising “uncomfortably fast”. And durable goods – for decades a source of disinflation – rose at an annualised 7.7% in the first quarter of the year. That reflects the effect of both tariffs and soaring prices for computer kit amid the AI boom.

The oil crisis has led to inevitable comparisons with the 1970s, says James Smith for ING Think. In some respects, the similarities are “striking”. Now as then, we face an energy shock emanating from Iran. Now as then, US government spending is unsustainably high. But in other ways we live in a quite different world. Per-capita oil consumption in the UK is 55% lower today than it was 50 years ago. In real terms, energy prices are well below the levels of the late 1970s, when they hit nearly $200 in today's money. Unionisation rates have collapsed since the 1970s and strike action is far rarer than it used to be, reducing the risks of a sustained inflationary surge.

Not that everything is rosy. In some respects, advanced economies face new sources of inflationary pressure that didn't exist in the 1970s. Populations are ageing and net migration is beginning to fall sharply because of stricter border policies. That threatens “shortages” of workers on a scale “with little precedent in the West”.

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Donald Trump has sworn in Kevin Warsh as the new chair of the US Federal Reserve, replacing Jerome Powell, in what was supposed to be the big monetary policy event of the year. Kevin Warsh, like all of Trump's preferred candidates for the Fed's board of governors, has sounded very keen to cut interest rates. Assuming that he was not simply paying lip service to the president's wishes in order to win the nomination, that would mean huge pressure in the Fed for aggressive easing. Yet it is no longer so clear that the change of chair will matter much.

The Middle East crisis has changed the calculation. Markets are now pricing in interest-rate rises rather than cuts, while longer-term bond yields are rising again. Of course, a central bank that is determined to slash short-term interest rates could ignore fears about inflation and cut regardless. It could also try to control long-term yields by buying up longer-dated bonds. But in this environment, it is far less likely that Trump's appointees will be able to shift consensus among other board members towards much looser policy. Nor is it obvious from his own record that Kevin Warsh will be quite so dovish for now, notwithstanding his frequently expressed view that AI will usher in productivity gains that justify structurally lower rates.

Interest rates are not Kevin Warsh's biggest problem

All else being equal, easier policy would have been even more bullish for already-exuberant stock markets, especially in the US. Yet investors have not been behaving as if policy was too restrictive anyway.

Note how strongly markets have risen with interest rates where they are. Short-term rates at around 4% and longer-term rates at around 5% only look high by the abnormal standards of the 2010s.

So the real risk to markets is not that interest-rate cuts don't come. Instead, it is the hard reality of where fears about inflation are coming from: the disruption to energy supplies. Every week, markets trade as if the crisis will be resolved; every week, we see no solid progress. If this finally starts to catch up with the real economy – which could happen in early June, some analysts reckon – the Fed's decision to tinker or not to tinker will quickly become irrelevant.

A date for your diary

The first of the twice-yearly Mello conferences for private investors takes place next month, on Tuesday 2 and Wednesday 3 June in West London. This event always features an interesting line-up of several dozen companies and funds presenting to existing and prospective investors: one of the highlights in last November's event was Seraphim Space, which has been the star of the investment-trust sector this year. Mello is offering MoneyWeek's readers a 25% discount on tickets – go to melloevents.com/mello2026 and use the code M26MW25 to book.

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What are prediction markets?

Prediction markets are online peer-to-peer exchanges that let users wager money not just on sports and politics, but on everything from the chances of a full US ground invasion in Iran to what colour tie Donald Trump will wear on a particular day. The two biggest sites, Polymarket and Kalshi, have exploded in popularity over the past two years, as US federal regulators have taken a far more relaxed approach.

Trading volumes on the two sites were $50 billion in 2025, up from $16 billion the year before, and are set to be many times that this year. According to analytics firm The Block, cited by The Wall Street Journal, trading volumes on the two leading platforms rocketed to $24.2 billion last month, up from $1.8 billion a year earlier. Donald Trump Jr is an adviser and investor in Polymarket, and Trump Sr's media company is planning its own site, Truth Predicts. Meanwhile, several US states are suing the firms on the grounds that they facilitate illegal gambling.

Are prediction markets risky?

Betting on events that might or might not happen is obviously wide open to people taking advantage of inside information and/or seeking to influence events. Last month, a US soldier was the first person to be charged with insider trading on prediction markets. Gannon Ken Van Dyke is charged with using classified information to place roughly 13 bets worth $33,034 on positions including “US Forces in Venezuela” and “Maduro out”.

The sites claim they serve an important wider function in terms of price and information discovery – indeed, the Federal Reserve, no less, recently published a paper finding that Kalshi's market participants did a usefully good job of predicting changes in interest rates and GDP. Polymarket says it “aggregates wisdom from informed users, often outperforming experts”. But if those users are too “informed”, it stacks the deck against the rest of the players. Exactly how “informed” a user is permitted to be before they are doing something illegal is a question that's certain to play out in the courts many times in forthcoming months and years.

Are prediction markets allowed in the UK?

In theory, both Polymarket and Kalshi are regarded as unlicensed gambling sites by UK authorities and are blocked to UK-based users. In practice, there are routes (involving VPNs and cryptowallets) available to those who wish to bet. This week, the site was offering 20 different markets related to the local and devolved government elections in the UK, including mayoral elections. Unless an awful lot of Americans have developed an unlikely expertise in Britain's local politics, it seems probable that the “informed users” in question are UK-based.

How do prediction markets work in practice?

The principle is similar to sports-betting exchanges, in that prediction markets involve peer-to-peer betting (or “trading” for those who fancy themselves as pros) rather than betting against a bookmaker. On Polymarket and its competitors, unlike a conventional bookmaker, the house doesn't set the odds: it facilitates a peer-to-peer exchange – all bets are binary Yes/ No – and takes a fee.

At the time of writing, Polymarket is offering a market on what the highest temperature will be in London on 7 May. A high temperature of 16˚C is priced at 39 cents, meaning the market of interested punters thinks that there's a 39% chance of that event happening. If you bet Yes – and get it right – you get a dollar, and have made 61 cents profit on each 39 cents you stumped up.

Can you trade your position?

Yes, you can sell out of either winning or losing positions before the event is resolved – and most users do just that. Say you buy Yes at 45%, and it moves to 55% as people think it's becoming more likely. You can cash out early and make a smaller profit of 10 cents. This is an important point in terms of market manipulation and abuse by insiders – you don't need to win your prediction to make money, you simply need to move market sentiment and cash out. On 9 April, for example, the official temperature recorded at Charles de Gaulle airport jumped suddenly before falling back. The spikes were due to suspected tampering with sensors and coincided with suspicious bets on Polymarket, with hundreds of thousands of dollars in play.

Do prediction markets facilitate corruption?

It appears so. According to analysis by the Anti-Corruption Data Collective, a non-profit research and advocacy group, more than half of “long-shot” bets on military action made on Polymarket – defined as wagers of $2,500 or more at odds of 35% or less – are successful. That suspiciously high average win rate (of 52%) compares with just 25% in politics and 14% for all long-shot markets. The day before the US attack on Iran on 28 February, 150 people made trades of at least $1,000 predicting an imminent strike.

The risks go beyond insider trading, says Sam Freedman on Substack. “The more lucrative these markets become, the more predictions about the future will affect decision-making and behaviour” – and the more public trust will erode as misinformation aimed at manipulating markets becomes widespread.

Should you have a punt?

For a bit of fun, maybe. As a way of making money, probably not. The Wall Street Journal finds that 70% of users lose money and that 67% of all profits on Polymarket go to just 0.1% of accounts. “Casual traders are bleeding cash while a small number of sophisticated pros – including trading firms with access to vast streams of data – eat their lunch.”

Separate analysis by Charles Martineau, a professor at Toronto, came up with similar results. His paper concluded that 69% of Polymarket customers lose money, while the top 1% captured three-quarters of the profits. On Kalshi, too, the large majority of users lose money, with 74% of accounts unprofitable over the past month (on the firm's own figures). Good luck beating those odds.

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I must admit to being rather disappointed that Donald Trump has chosen the wrong Kevin to be the next chair of the Federal Reserve. For many months, Kevin Hassett – who investors with long memories may know as the author of the laughable Dow 36,000 – sat in pole position. Appointing him would not have been good for the Federal Reserve’s credibility, but his obsequious enthusiasm for cutting interest rates promised to be very entertaining. Sadly, Trump changed his mind, and we have been robbed of the central bank boss that our peculiar times deserve.

Still, any idea that Kevin Warsh will be some kind of interest-rate hawk does not sound plausible, regardless of his position when he was last at the Federal Reserve 15 years ago. He appears to be in favour of cutting short-term rates aggressively, if not quite as aggressively as Hassett. At the same time, he also wants to shrink the Fed’s bond holdings. The latter course of action should, in theory, mean higher long-term yields, since the Fed will no longer be mopping up so many longer-dated bonds, and a steeper yield curve. How that squares with treasury secretary Scott Bessent’s desire to cap longer-term yields is unclear, to say the least. All told, the outlook could get quite confusing.

The Federal Reserve is an institution that Republicans still seem to care about

Of course, this assumes Warsh is confirmed as chair and manages to get enough of the Fed governors on his side, which is by no means certain. One of the few US institutions the Supreme Court and Republican senators still seem to care about shielding from presidential whim is the cargo cult of modern central banking. Trump has been able to get away with extreme levels of overreach in practically every sphere, but giving him free rein over the panel of technocrats who can supposedly guide the direction of a $30trillion economy by tinkering with interest rates is apparently a step too far. Nonetheless, past experience suggests he will more or less get his way. If so, Warsh’s statements seem consistent with how our asset-allocation portfolio is positioned. We remain concerned that longer-term bonds offer too little compensation for the risk of higher yields and higher inflation (not just in the US but in the UK and elsewhere) and so we are sticking to short-term bonds.

Part of our protection against central banks getting it badly wrong is our 10% allocation to gold. I am doubtful that the rapid sell-off in gold at the end of last week had much to do with Warsh’s appointment, even though that explanation has been widely quoted. Metals had rocketed the previous week with clear signs of speculative excess; a pull-back was overdue. Huge moves in data and digital companies that might – or might not – be affected by AI point to a twitchy and volatile market in any case.

We are not making any changes to our holdings, but investors who have held gold for a while may find that it now accounts for a much larger share of their portfolio than originally intended. If you find that you are now heavily overweight, you may want to trim a bit back to target. We will do this in our regular rebalance at the end of the tax year.

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Donald Trump has picked Kevin Warsh as the new chairman of the Federal Reserve, the US central bank, after months of very public arguments. The markets liked the choice. Equities rose on the news and gold tumbled as investors decided they no longer needed to hedge against the collapse of the dollar. Warsh is an experienced banker and policy-maker, but he is also close to the Trump circle, and in the past has advocated bold reforms of the way monetary policy is set. Given that Trump could easily have appointed Elon Musk, or one of his children, or even Melania, Warsh is seen as a relatively safe pair of hands.

Still, the challenges Warsh faces are daunting. First, he will have to re-establish the independence of the central bank. Trump has very clearly been trying to bring the Fed under political control, pushing it to cut interest rates even though it is far from certain that inflation is not going to start rising again. The incumbent, Jerome Powell, is facing legal action for overspending on the Fed’s new headquarters. The markets are not going to trust a Trump stooge and especially one who looks willing to start printing money to finance the president’s lavish spending and tax cuts. At some point, Kevin Warsh will have to make it clear that he is in charge, not the president. If he doesn’t, and if he seems to be conceding to Trump’s demand to juice the economy, especially ahead of the mid-term elections due later this year, the sell-off of the dollar, and Treasury bills, will start up all over again, and perhaps more savagely.

Next, Warsh needs to persuade both the White House and Congress that the deficit genuinely matters. The US economy is in robust health, but the budget deficit is still running at more than 5% of GDP and there are no plans to bring it under control. The US state has become addicted to borrowing to finance its spending. The last president to actually balance the books was Bill Clinton at the start of the century. The US has managed to get away with it so far, racking up bigger and bigger debts with every year that passes. But it has benefited from its reserve currency status, and it has been able to mop up huge amounts of Chinese savings. None of that will necessarily last forever. Warsh needs to find a way of getting the Senate, Congress and White House to control spending and, if necessary, raise taxes. The US can’t run deficits forever without risking ruinous inflation.

Thirdly, the new Fed chair needs to reinvent the dollar for a post-globalisation world. Trump has made it clear he does not want the US to finance the global trading system, that he is determined to bring free trade under control, and he wants to put America first. That is why he has ripped up the free-trade consensus and imposed the steepest tariffs since the 1930s. Whether the dollar can remain the global reserve currency in those circumstances is far from clear. Indeed, there is already evidence that central banks around the world are diversifying into gold and even bitcoin. The European Central Bank is too weak to influence anything, but China is carving out a global role for the yuan, and that is only going to grow in significance. What is the role of the Fed in all of that? Warsh will need answers, or else be left floundering as the world changes around him.

Kevin Warsh will need to calm the AI bubble

Finally, Kevin Warsh needs to calm an AI and tech bubble that has run out of control. AI is clearly a major new technology, and will create huge business opportunities, but it is also clear that investors have driven valuations far too high, just as they did at the height of the first internet boom a quarter of a century ago. Likewise, a handful of leading tech stocks have dominated the global markets. Sure, it will be great for the US economy that so much money is invested in the technology, with more than $100 billion poured into data centres and start-ups over the last year. It will pay off eventually in terms of new products and higher productivity, and it is a lot more impressive than anything that is happening in Europe. Even so, a crash will derail that, and once it starts may easily run out of control. The trick for Warsh will be to curb what one of his predecessors, Alan Greenspan, described as “irrational exuberance” without the entire market collapsing. It will not be easy. But he will have to try all the same. If the bubble carries on for another year, it will be too late.

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It is a bizarre legal action. Jerome Powell, the chairman of the Federal Reserve, the US central bank, has been prosecuted over renovations of the Fed’s headquarters and may now face criminal charges. Given that it manages an economy worth $30trillion and the world’s reserve currency, it is hard to see that the $2.5billion spent on improving the Fed’s offices really matters much. Even so, Donald Trump has clearly decided to use it as a weapon for a full-scale assault on a Fed chairman he would prefer to get rid of.

Powell himself was clear that the legal attack was just a way of bringing the Fed to heel. “The threat of criminal charges is a consequence of the Federal Reserve setting interest rates based on our best assessment of what will serve the public, rather than following the preference of the president,” he said in a statement. In other words, it is a political attack on the Fed and an attempt to allow the president to control monetary policy. If Powell is removed from office by the courts, whoever is appointed to replace him will clearly be taking instructions directly from the White House.

That is a dramatic and dangerous development. This is not to deny that independent central banks are worthy of criticism. Over the past 30 years, they have become too powerful, too confident in their own abilities and too quick to print money. You can make a case that, instead of ensuring greater stability, which is what they were meant to do, independent banks have inflated a series of asset bubbles, indulged spendthrift politicians and prioritised trendy causes while allowing industry to be hollowed out. There is a case for reform. Still, there is a big difference between that and a power grab to hand the right to set rates to the White House.

There are two big problems with that. First, it looks as if Trump is determined to control interest rates himself, either directly, or else through a tame proxy at the Fed. That is not without precedent. In Britain, interest rates used to be set by the chancellor, but the result was that the UK had one of the worst records on inflation in the world before Gordon Brown made the Bank of England independent in 1997. And it is hard to think of a worse person to set rates than Trump. He is temperamental, he constantly changes his mind, he doesn’t listen to advice, and his falling approval ratings mean he will constantly try to cut rates to boost short-term demand. Even more seriously, if the president acquires the right to set rates, it’s hard to see how it will ever be given up. It is too major a power to surrender. The US will have a politicised monetary policy permanently.

How bad will it get under Trump?

Everything else the president is doing appears designed to stop the free market working and drive up prices. The US has already imposed the steepest tariffs since the 1930s, with an average levy on imports of 18%. Closing off its markets to global competition will only drive prices higher and quality down. Only last weekend, Trump promised to cap credit-card interest at 10%, the kind of populist policy you would expect from the far left. Trump has also started capping corporate investment in the housing market. He is directing the oil companies to invest in Venezuela regardless of whether there is an investment case for it or not (with oil at $50 a barrel, there probably isn’t). There does not appear to be a coherent plan, but a whole series of interventions to create markets rigged by the government. State-controlled economies always end up with higher prices.

Add it all up, and one thing is clear – sooner or later the US will see a major rise in inflation. How bad will it get? There is no way of knowing for certain, and it will depend on what else is happening in the global economy. But once prices start to rise we know they are very hard to bring under control again. And if US prices rise, that will drive global prices higher. We can expect inflation to spread to Britain and the rest of Europe very quickly. Investors are already positioning themselves for that, with the price of gold hitting record highs every week. Prices of defensive assets will inevitably go a lot higher.

While the US dollar was continually getting stronger and sterling was continually getting weaker, British investors rarely needed to worry too much about currency movements. If you held an international fund that was benchmarked to the MSCI World or a similar index, your currency exposure was around 60%-70% to the US dollar and the trend worked in your favour.

If the era of the strong dollar is over – and the Trump administration’s policies imply that it probably is – that will no longer work in our favour.

Even if the US stockmarket keeps going up – which is quite possible if the US Federal Reserve cuts rates aggressively – a weaker dollar would mean much lower gains for foreign investors.

One obvious conclusion is that investors will give much more thought to whether they should hedge currency exposure – eg, by buying currency hedged classes of exchange traded funds (ETFs).

For example, an ETF such as iShares Core S&P 500 is available both as a share class that is quoted in sterling (LSE: CSP1) and one that is hedged into sterling (LSE: GSPX). The first will be affected by how the dollar moves against sterling. The latter will be hedged against it to some extent – but there will be a limit to this as well.

How currency hedged funds work

To understand why even a currency hedged fund won’t insulate us from currency movements completely over the long term, it’s useful to think about how funds hedge currency exposure.

Hedging means using forward contracts to lock in the exchange rate at which the investor will buy or sell a certain amount of the currency on a future date.

Of course, the exchange rate that is locked in will not be the same as today’s exchange rate. For every currency pair such as the sterling and the dollar, there will be a forward rate for a transaction in one month, one year, five years and so on. The forward price should depend on the difference in expected interest rates over that time period. If it did not, an investor could earn risk-free profits by borrowing in one currency; investing the proceeds at a fixed interest rate in a different currency for one month; and buying a forward contract to exchange the second currency back into the first currency (and repay the money borrowed) without taking any risk of how exchange rates will change.

If you have very certain long-term cash flows – eg, from an infrastructure project – you can enter into very exact hedges. You buy forwards to perfectly match the foreign currency you expect to receive when you receive it. This is not true for most equity or bond ETFs or funds, where future returns may be uncertain and where money may flow in and out of your fund all the time. So a currency hedged fund typically enters into a series of short-term forwards, which it continually rolls over. This certainly helps smooth out currency volatility – but in a world in which interest-rate expectations and hence forward exchange rates become more volatile, it may not always work as well as investors expect.

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Over the past couple of weeks, we have seen unusually open debates and divergent views about the path of short-term interest rates among the committee members of the US Federal Reserve (the Fed) and the Bank of England (BoE). Professional Fed watchers are in a spin. What is the problem all of a sudden? And why is the debate happening so publicly? Where is the certainty previously displayed by these policymakers, always confident that they can control inflation via the setting of short-term interest rates? All is not right in the rarefied world of central banking.

The cornerstone of monetary policy in recent decades has been the perceived independence of central banks from political influence. The idea was that we could trust politicians more if our monetary policy was set and executed by an independent technocratic committee of experts acting in the public interest. UK gilt investors welcomed this initiative in 1997 when Gordon Brown granted the Bank operational independence.

But things have changed. The UK electorate has grown to distrust its politicians and its institutions. The British Social Attitudes Survey in 2000 showed that 35%-40% of adults believed that the government would put the country’s interests first. Last year, the same measure was 9%-14%, with 58% saying that they rarely trusted politicians to tell the truth.

The hard truth is that a central bank cannot function without government funding and authority, and cannot be genuinely independent. Most bond investors understand this; however, it has, until recently, been what we might call uncommon knowledge. Things have changed, and the notion of central-bank independence is being openly questioned – primarily in the US, but also increasingly in the UK.

Fiscal dominance

Donald Trump lives in the public domain. He became a household name via reality TV and conducts public policy via social media. Conventionally, it’s thought that like sausages, government policies are better not seen being made. However, Trump does things differently and since April, has variously referred to his Chair of the Federal Reserve on Truth Social as “Jerome ‘Too Late’ Powell”; “Too Angry, Too Stupid, & Too Political”; “TOTAL LOSER”; “A FOOL”; “Stubborn MORON”; “and “the Worst”.

From a political perspective, what the electorate is witnessing might be the consequence of trying to divert public attention, maybe from the bombing of Iran or the contents of the “Epstein files”. However, the underlying economic driver here is what economists call fiscal dominance. As Ray Bourne, of the Cato Institute, puts it: “Under fiscal dominance, monetary and financial policies get subordinated to support the government’s financing needs, with more tolerance for high inflation... long-term, the graver danger to central bank autonomy isn’t Trump’s tweeting – it’s US politicians’ borrowing.”

In short, beyond the event horizon of out-of-control sovereign debt, accepted rules and market correlations stop functioning. Just like in a black hole where the accepted laws of physics no longer apply, so too in a world of fiscal black holes, the accepted norms of central banking monetary policy stop working. For context, the US federal deficit has increased by $1 trillion, or 2.8%, since the passage of the “big beautiful bill”, and the raising of the debt ceiling last month, and now stands at $37.2 trillion.

The annual campout for the world’s under-siege central bankers in Jackson Hole later this month can’t come soon enough. This year’s theme is “Labour Markets in Transition: Demographics, Productivity, and Macroeconomic Policy”. But between official proceedings, time will be found to discuss the real agenda occupying them: how do we remain independent, or at least appear to be independent, and how can we pretend inflation targeting is even possible in a fiscally dominant world?

While Trump overtly undermines, insults and publicly humiliates his Fed chairman, in the UK, we do things more subtly. This week, both Keir Starmer and Rachel Reeves claimed the Bank’s ambiguous “hawkish cut” decision to lower UK policy rates as evidence of their successful stewardship of the UK economy. It was, they said, all part of their orchestrated plan to put the UK on a more secure economic footing.

Aside from the (lack of) independence point, there are two issues here. First, market interest rates that set the government’s cost of borrowing rose sharply following the BoE decision. UK gilt yields from one-year to 30 years’ duration rose as the bond vigilantes sharpened their axes. Second, the BoE’s governor, Andrew Bailey, said with a straight face that he thought that they needed to cut rates even though he expects inflation to “temporarily increase” to 4% next month. Is this the same as transitory? Note that the UK’s inflation rate has been above target in 48 out of the last 50 months. Sure, the world is getting riskier, but their models are no longer fit for purpose in a fiscally dominant world, nor are their proponents.

The pretence under which the Fed and BoE operate is becoming too obvious to ignore. Their work is increasingly conflicted with their fiscally irresponsible political masters, who can no longer afford for their independent monetary experts to achieve their mandates. So say goodbye to the era of central bank orthodoxy and hello to the new era of central bank dependency. There’s a new boss in town with different ideas. As they might say in Wyoming, inflation ain’t going nowhere. There’s a new sheriff in town, and he kinda likes it.

A version of this article was first published by wealth management group Dowgate Wealth.

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What’s the beef between Jerome Powell and Donald Trump?

US president Donald Trump wants a looser monetary policy – lower interest rates – to get the economy growing and mitigate the impact of the ballooning US federal debt. Jerome Powell, the chairman of the Federal Reserve, the US central bank, sees his job as to resist that political pressure and is determined to carry on targeting inflation as the best way of ensuring long-term economic stability and growth. It’s an age-old (or at least decades-old) story of tension between elected leaders and “independent” central bankers. But in the case of Trump and Powell, there’s genuine animus and the stakes are exceptionally high. Trump himself appointed Powell (a Republican ex-investment banker) to the job as Federal Reserve chairman in his first term in 2018. But Trump quickly regretted his decision due to Powell’s refusal to bow to political pressure. Within months, the president was publicly attacking Powell as “crazy” for continuing to gradually raise interest rates and unwind America’s quantitative easing.

Why not sack Jerome Powell?

A president can’t sack a Fed chair over differences on monetary policy. He can only sack them “for cause” – meaning malfeasance of some kind. Powell’s term as the Fed governor (though not as a board member, should he choose to stay on) ends in May next year, at which point Trump will no doubt try to find someone more malleable. In the meantime, Trump’s undermining of Powell has become toxic. The Fed has kept borrowing costs on hold at between 4.25% and 4.5% this year, even as other central banks have cut. That’s partly, by Powell’s own account, due to April’s “liberation day” tariffs and their upward impact on US inflation forecasts. Were it not for that fresh negative factor, the Fed “would probably have cut rates [again] by now”, said Powell last month. In response, Trump has become increasingly abusive – attacking Powell as a “numbskull”and “complete moron”.

Why is Trump so angry?

Because the political stakes are unusually high, the US federal debt is unusually high and Trump is an unusual president. “It’s pretty universal having a president who wants lower rates,” says Don Kohn, a former Fed vice-chair. “What’s unprecedented is [Trump] doesn’t want lower rates to goose the economy, [for him] it’s about lowering the cost of the debt. That’s worrisome because keying monetary policy to relieving budget pressures is a sure track towards higher inflation.” Last month, Trump claimed Powell’s reluctance to cut rates – “at least three points too high”, says Trump – was “costing the US $360 billion a percentage point in refinancing costs”. That’s a trillion dollars worth of anger, which has expressed itself in mounting public frustration, including presidential musings on whether to fire Powell, and a tense on-camera spat over the cost of Fed renovations – as Trump apparently hunts for a just “cause” to replace the governor.

Why does all this matter?

Because it has undermined market confidence in the independence of the Fed and the stability of US policymaking – sending the dollar sharply lower this year and making a bond-market crisis more likely, as investors (fearing their loans would be repaid in a depreciated currency) demand higher interest rates. Last week, in a rare rebuke – albeit one that didn’t name the US, its biggest shareholder – the International Monetary Fund warned that undermining central-bank independence risked triggering a debt crisis and that independent monetary policy is “a cornerstone of macroeconomic, monetary and financial stability”. In the case of the US, that matters to all of us. An increase in US credit risk due to concerns regarding fiscal sustainability could make financial markets excessively volatile.

Are central banks independent?

Over the past half-century it’s become the norm for central banks to be at least nominally independent in rich-world economies. The idea is that politicians can’t be trusted to run monetary policy because they are too influenced by short-term political considerations. Giving the Bank of England independence was first mooted by Nigel Lawson in the 1980s and finally happened in 1997 under Gordon Brown. By contrast, Germany’s Bundesbank, the first central bank to gain full operational independence (in 1957), was central to the Federal Republic’s relative price stability and economic outperformance. In the US, the Fed has notionally been independent since 1951. But the institution remains haunted by the blunder of chairman Arthur Burns, who was pressured by president Richard Nixon to cut interest rates in the run-up to the 1972 election – ultimately leading to disastrous “stagflation”.

Independence is better, then?

It’s simply a means to deliver superior price stability and economic performance. There is historic evidence, dating from the 1980s onwards, that independent central banks tend to foster greater price stability. But the charge that independence removes democratic accountability became more potent in the wake of the 2007-2008 financial crisis, as banks became more powerful and pursued highly politicised and contentious strategies such as quantitative easing. There has also been much less consensus over the purpose of monetary policy in an era of low inflation and low growth. Why target inflation when the real issue is stagnation? Central banks also struggled to cope with the post-pandemic inflationary shock, further undermining faith in their technocratic omniscience.

So Trump is right?

As with many of his views, there’s a kernel of truth. But any attempt to curb the Federal Reserve’s independence – especially when it comes to rate-setting – would be very bad news for financial markets. As John Authers puts it on Bloomberg, “Independence may be the worst form of central banking – except for all the others.”

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It is no secret that US president Donald Trump is not a fan of Jerome “Jay” Powell, the chairman of the US Federal Reserve (Fed). Last Thursday, 17 April, he took his criticism up a notch when he threatened to fire Powell, saying his “termination” could not come “fast enough”.

The move constituted a significant overstep. The Fed is independent, meaning it sets interest rates without interference from the White House or Congress. Politicians generally respect this.

The main thing irking Trump is Powell’s refusal to lower interest rates quickly. On the campaign trail, Trump promised to relieve pressure on households by reducing borrowing costs – a decision that lies outside of the president’s power.

Markets responded negatively to Trump’s comments when they opened after the Easter weekend. The S&P 500 closed 2.4% lower on Monday, while the Nasdaq 100 fell 2.5%. The dollar also weakened, while gold and long-term Treasury yields rose.

Trump quickly backtracked on Tuesday, 22 April, telling reporters that he has “no intention” of firing Powell. “I would like to see him be a little more active in terms of his idea to lower interest rates,” he added. Markets jumped on the news.

As well as Trump’s comments on Powell, the rebound was partly driven by the suggestion that the US might come to an agreement with China, after Treasury secretary Scott Bessent said the trade war was unsustainable.

“These comments have given markets a sense of optimism that recent chaos might have peaked and we’re heading towards calmer waters. It almost suggests that someone has taken Trump to one side and told him it’s time to be more responsible with his words and actions,” said Russ Mould, investment director at AJ Bell.

While a temporary sense of calm has been restored, the episode raises questions about the Fed’s independence and how much power the president has over the US central bank. Can Trump fire Powell – and what would it mean for markets?

Can Trump fire the chair of the Fed?

The chairman of the US Federal Reserve is nominated by the US president and confirmed by the Senate, however it is an independent role. The chair serves a four-year term and can be reappointed several times.

Powell was originally nominated by Trump in 2017 during his first term as president, before relations between the two soured. He was nominated for a second term by Biden in 2022.

Speaking in Chicago last week, Powell said the Fed’s independence is “very widely understood and supported in Washington and in Congress where it really matters”. He added that the central bank was “never going to be influenced” by political pressure. “We will only make our decisions based on our best thinking… our best analysis of the data.”

Despite this, lawyers recently told the Supreme Court that the Fed’s independence could be left vulnerable, should Trump’s recent firing of two Democrats be allowed to stand. Cathy Harris and Gwynne Wilcox were dismissed from two federal labour boards before their terms expired.

The implication is that this could set a dangerous precedent for other independent agencies.

What’s behind Trump’s criticism of Powell?

Trump’s argument with Powell goes back to the fact that he wants interest rates to fall more quickly.

The Fed has cut interest rates three times from their peak, bringing the federal funds rate to a range of 4.25-4.5%. The first cut was a large one at 50 basis points (September), with two 25 basis-point cuts after that (August and December).

At the latest rate-setting meeting in March, Powell suggested two more 25 basis-point cuts could be in store this year, however he also pointed to “heightened uncertainty” in the US economy, driven by the Trump administration.

“The new administration is in the process of implementing significant policy changes in four distinct areas: trade, immigration, fiscal policy, and regulation. It is the net effect of these policy changes that will matter for the economy and for the path of monetary policy,” he said.

“While there have been recent developments in some of these areas, especially trade policy, uncertainty around the changes and their effects on the economic outlook is high.”

Writing on his social media platform Truth Social on Thursday, Trump said: “The [European Central Bank] is expected to cut interest rates for the 7th time, and yet, ‘Too Late’ Jerome Powell of the Fed, who is always TOO LATE AND WRONG, yesterday issued a report which was another, and typical, complete ‘mess!’

“Oil prices are down, groceries (even eggs!) are down, and the USA is getting RICH ON TARIFFS. Too Late should have lowered Interest Rates, like the ECB, long ago, but he should certainly lower them now.”

Most economists disagree with Trump’s argument that tariffs will make Americans “rich”. Tariffs are essentially an import tax, paid by businesses and passed on to consumers in the form of higher prices.

If US inflation rises as a result of Trump’s trade policy, it could delay further interest rate cuts rather than opening the door to them.

The alternative scenario is that tariffs prove so damaging to economic growth that the Fed is forced to cut rates to support the economy – but for the wrong reasons (recessionary risks) rather than the right ones (slowing inflation).

In its latest economic outlook, the International Monetary Fund (IMF) has projected a “significant slowdown” in the US economy. It now expects growth to come in at 1.8% in 2025, down from its previous forecast of 2.7%.

While the institution is not currently forecasting a recession, it says the risk of one occurring has increased from odds of 25% to around 40%.

Why does central bank independence matter?

The Fed has a dual mandate – to promote maximum employment and price stability. To successfully achieve this, it needs to take a view that is both long-term and impartial.

Squashing inflation out of the economy, for example, has involved painful decisions. Many households and businesses are still struggling to pay off mortgages and debts as a result of higher interest rates. Someone courting public opinion may have struggled to make the necessary moves.

“The critical thing is to make sure that inflation expectations remain anchored; that everyone remains convinced that central banks will do what is necessary to bring inflation back to central bank targets in an orderly manner,” said Pierre-Olivier Gourinchas, economic counsellor at the IMF.

“Central banks have the instruments to do this. They have their interest rate instruments. They have various instruments of monetary policy. But one critical aspect of what they do comes from their credibility. So central banks need to remain credible. And part of that credibility is built upon central bank independence.”

What do Trump’s threats mean for investors?

Any threats to central bank independence are bad news for investors and the wider US economy.

Firstly, interference from the president would damage central bank credibility, adding to the risk of persistently higher inflation and therefore interest rates. In other words, Trump could end up undermining his own objectives.

Furthermore, lower short-term interest rates would probably come at the expense of a jump in longer-term Treasury yields, according to Samuel Tombs, chief US economist at Pantheon Macroeconomics. He points out that these matter more for the real economy.

Tombs suggests investors would “bake in a greater risk premium”, anticipating “more inflation and hence the need for tighter monetary policy in the future”.

Meanwhile, “higher corporate bond yields and lower stock prices would make financing more, rather than less, expensive for many private companies, offset only in part by the boost to exports from a weaker dollar”.

Monday’s “ugly moves” in financial markets are just “a taste of what would follow if Trump aggressively attacked the Fed’s independence”, according to Tombs. Investors will be breathing a sigh of relief now that Trump has backed down – and hoping he stays there.

The gnostic utterances of Jerome Powell, chairman of the American central bank, are these days pored over ever more intently by investors and analysts seeking to divine the future direction of interest rates. And for good reason: the interest rate set by the Federal Reserve is the most important number in the financial markets. The US is the world’s most important economy and its markets set the tone for global asset prices.

What investors want to know above all is the likely future direction of the Fed’s “benchmark federal funds rate”, the rate at which banks borrow from each other overnight, which in turn is deemed to have a powerful influence on other interest rates, including those paid for business or personal loans or mortgages, or earned on savings. Globally it will have a big impact on whether money flows into or out of emerging markets, for example, with knock-on effects everywhere.

In short, the number the Fed comes up with has a big influence on whether the world is making as good a living as it could be. If businesses are going to make new investments to produce more or become more productive or make a venture into new products or services, they need households and other savers to supply the capital to finance it. Balanced, stable growth demands that total investment in the economy be equal to the pool of available capital or savings.

For that to happen, interest rates need to be high enough to convince savers to save and low enough to incentivise borrowers to borrow, as the Brookings Institution explains. The interest rate that achieves this over the long run is known as the “neutral rate”. The Fed sets the rate above the neutral rate if it wants to cool an economy it thinks is overheating or below it if it wants to stimulate a flagging economy. It’s vital that the price is right.

It would seem to be a bit of a problem, then, that central bankers and other economic experts can’t agree on what the neutral rate actually is. It has long been the subject of intense debate, one that heated up in recent years as economists disagreed over whether the higher interest rates introduced post-Covid to restrain inflation had gone too high and were hence holding the economy back. The neutral rate – also known as the long-run equilibrium interest rate, the natural rate, or r* – is defined as the short-term interest rate that would prevail if the economy were at full employment and inflation stable, and if monetary policy were neither contractionary nor expansionary. In the long run, it is determined by the supply of and demand for savings.

But it is a theoretical concept, not something that can actually be observed in the wild. The Fed does not set the neutral rate, it just tries to estimate what it is. Economists use different models to try to pin it down, and estimates of what it might be vary. Some even insist that it doesn’t exist – that it makes no sense to try to estimate a single, economy-wide interest rate. That would be awkward for the Fed, which bases its most important decisions on some measure of it.

All of which goes to illustrate a puzzle about our societies – that monetary policy, as practised in the US, the UK and many other countries, assumes that central bankers, as central planners, can do a better job than financial markets in setting rates that will maximise economic output and stability while keeping a lid on inflation, even if they are, as they must be, flying blind. Why? We don’t have a central authority to set the price of food or shoes. Why do we need one to set the price of money and retain monopoly control over the supply of it? Why not privatise money?

Is there an alternative to central banks?

The idea that central banks are a necessary feature of modern economies has long “reigned supreme and is virtually unquestioned” in economics, as Kevin Dowd points out in The Experience of Free Banking (IEA, 2023), a collection of essays reissued last year. Even economists who are generally sympathetic to laissez-faire, such as Milton Friedman, accepted that money and banking could not just be left to markets. The issue of the national currency was deemed to be a “natural monopoly” that was properly the responsibility of the state, or more recently of central banks under the auspices of the state. There has, of course, been plenty of controversy over how much power the central bank should have and just what it should do, as Dowd points out, but no respectable economist suggested that central banks should be abolished – until, that is, Friedrich Hayek suggested in 1976 that the only way to achieve monetary stability was to “denationalise money”.

The most extreme version of the theories that developed following his suggestion advocates the abolition of central banks and the introduction instead of a system of “free banking”, defined as a system in which private banks are free to issue their own money under competitive conditions, typically convertible into gold or some other commodity standard, and in a legal environment in which the public is free to accept or reject bank currency as they see fit. That might sound impossibly radical, but following Hayek’s suggestion a major research effort revealed that free-banking systems had existed in the past and that they had indeed a long and respectable history. Dowd’s book presents an overview of the world experience of free banking, with examples from Australia, Belgium, Canada, Chile, Colombia, China, France, America, Italy, Sweden and Switzerland.

Perhaps the best-known example, however, is Scotland prior to 1844, thanks in part to Adam Smith’s assessment in The Wealth of Nations that its free banking system had contributed in a major way to the country’s economic development. In 1745, says Dowd, per capita income in Scotland was about half what it was in England at the time. A century later – a century that corresponds to the heyday of Scottish free banking – Scottish per capita income had risen to almost English levels despite England’s own rapid growth, and despite suffering a number of disadvantages, such as greater distance to markets, inferior infrastructure and fewer raw materials.

Competition between the free banks was fierce, and the fight for market share honed bankers’ liquidity and capital-management policies, their entrepreneurial skills and willingness to innovate. Banks provided commerce and industry with easy access to credit that was both inexpensive and relatively easy to obtain, provided the public with loans and monetary notes that were more convenient and easier to hold than coins, and promoted habits of thrift by offering them higher returns on their savings than they could obtain elsewhere.

Walter Scott wittily defended the Scottish system against its detractors in a way that might remind you of those economists beavering away in the Fed: “Here stands Theory, a scroll in her hand, full of deep and mysterious combinations of figures, the least failure in any one of which may alter the result entirely, and which you must take on trust … There lies before you a practical System, successful for upwards of a century. The one allures you with promises, as the saying goes, of untold gold, the other appeals to miracles already wrought in your behalf. The one shows you provinces, the wealth of which has been tripled under her management – the other, a problem which has never been practically solved. Here you have a pamphlet – there a fishing town – here the long-continued prosperity of a whole nation – and there the opinion of a professor of Economics, that in such circumstances she ought not by true principles to have prospered at all.”

The historical experience of free banking, both in Scotland and around the world, shows that the conventional wisdom about what would result from such an experiment must be rejected, concludes Dowd. Free banking systems were not in fact prone to inflation, competition did not destabilise them, and there’s some evidence that interest rates were more stable. The banks had to be careful and prudent in their lending, reserve and capital policies because they could not expect others to shoulder their losses or bail them out. Banks did sometimes fail under these laissez-faire conditions, but the failures do not appear to have been seriously contagious and major crises were rare. Indeed, where such crises did occur, they could usually be attributed to state pressure for cheap loans from the banks, which undermined their financial health, or to other forms of state intervention. Free banking – as in Scotland, for example – generally ended, says Dowd, because it was suppressed for political, fiscal or ideological reasons, and not because of any inherent flaws.

Walter Bagehot deemed central banking irreversible. Economic historian Charles Kindleberger noted a “strong revealed preference in history for a sole issuer” of currency. But the preference that history really reveals is that of the fiscal authorities, not of money users, as Lawrence White and George Selgin, two of the authors in Dowd’s book, have pointed out. In some places, such as London, free banking never received a trial for that reason. “Central banks primarily arose, directly or indirectly, from legislation that created privileges to promote the fiscal interests of the state or the rent-seeking interests of privileged bankers, not from market forces.”

Could it happen again?

Does any of this have relevance to the modern world? The historical record, according to the free banking advocates, shows that free banking, unlike the system of central banks, is not prone to inflation or banking instability. Those are features that would seem to be worth having. And if it worked in the past, then why not now? In theory, it seems, none at all. But there’s the small matter of the real world. Free banking, as Dowd admits, is not in the so-called “Overton Window” – that narrow range of policy options deemed to be politically possible. But even were that window to shift – as happens especially during crises – the case for free banking to date has relied heavily on theoretical arguments and history drawn from the 18th and 19th centuries, as a 2012 paper from the Cato Institute by Gerald O’Driscoll pointed out. However persuasive the arguments, they would come up against institutional inertia. Even if we agree that it would have been better if central banking had never been, the cost/benefit calculation for abolishing it has not been convincingly made.

The world of old in which free banking thrived is simply not the one we live in. None of the examples in Dowd’s book, extend far into the 20th century. The world in the preceding centuries was not as deeply interconnected through the financial system as it is today, and any proposal that we change that system must start from where we are – which is not a blank page, but a world where the incredibly complex, regulated, scaled-up infrastructure of modern banking already exists. And it works: the world with central banks is in many ways a better place than it was just a few generations ago and it continues to deliver material progress. Is it really sensible to think now about beginning anew? How would the change be carried out, and at what risk? Which piece of this complicated Jenga of a system would you pull out? And once pulled, just how confident are we that what will result will be stable? Even if it wobbles and doesn’t fall, will we be left with a structure that is radically better than what stood before? Is it worth playing the game given the risks we can think of, not to mention the unknown unknowns?

Under the current system, for example, we have instant transfer of capital, and relatively unfettered global trade in goods and services, where we pay for goods in our own currencies into a foreign bank account and don’t even need to think about all the complexities. How would that work under free banking? Will my pound from NatWest be accepted in the US, and how many pounds from HSBC is it worth? Will each bank have different exchange rates? The system instantly becomes incredibly more complex, increasing trade friction and transaction costs. Imagine we did in fact live in such a world. Wouldn’t a simpler system, where there is centralisation and central banks, to help ease some of these issues, seem very attractive?

It’s far from obvious, in short, that it would be worth the bother and risk of switching from central banks to an alternative system that has not been tried in the modern world, and this fundamental problem is not one addressed very deeply by free banking advocates. Perhaps that’s why the Fed is still fumbling around in the dark for a number that might not even exist. There’s simply no alternative.

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If you read the financial news this week you will see that everyone is talking about interest-rate cuts. The most prominent discussion on this topic is in the US, in the run-up to the election. Supporters of the Democratic Party have been crying out for the US Federal Reserve to lower interest rates, and at the end of September, the Fed obliged, handing the incumbent party a large 0.5% decrease in borrowing rates. Whether this will feed through to the economy by election day is doubtful, but it certainly gives those looking to take out mortgages in the near future some economic hope.

Now “lower-rate fever” is spreading to Europe. In this case, politics are not playing a leading role in the debate. Rather, technocrats and investors want to get back to what used to be called the “new normal”, but which is starting to feel like the old normal: stagnation, permanently low rates, and occasional bouts of monetary easing. Clearly both the technocrats and market participants have realised over the past few years that although economic stagnation and low rates might not be optimal, they are preferable to economic stagnation, inflation and interest rate hikes.

What will happen to interest rates?

Investors are now talking openly about interest rates in Europe halving by this time next year, falling from 3.5% to 1.75%. This follows from the annual rate of European consumer price inflation falling from 2.2% in August to 1.8% in September, meaning that for the first time since June 2021, inflation in Europe has been below the European Central Bank’s 2% target.

The broader economic backdrop looks grim for Europe too, with Citi Group’s economic surprise indicator being underwater since the summer (negative surprises in the data are outweighing positive ones); investors do not have very high hopes for Europe’s economy now, but the data is disappointing even those inclined to low spirits.

But this could be an instance of investors being lulled into a false sense of security. Just as market watchers are eager to get back to the old-new normal of low interest rates and stagnation, they want to put the geopolitical shocks that caused the recent inflation – namely, the Covid lockdowns and the Russia-Ukraine war – behind them. Yet when we turn the page of the newspaper from the economy to foreign affairs, we see that the Middle East is a tinderbox – a single spark could set it off. As the Scottish poet Robert Burns once observed, the best-laid plans of mice and men can often go awry – and he could well have been referring to those who are hoping our economies settle back into a sadly stagnant, but uneventful, calm.

Impact of a wider Middle East conflict on global markets

The increased risks have been there in the Middle East since Hamas launched its attack on Israel on 7 October last year. The response from the Israeli government immediately signalled that it was not willing simply to return to business as usual; it was committed to the eradication of Hamas. At the time, those following the situation closely noted that Hezbollah, an ally of Hamas based in Lebanon, to the north, was also engaged in a campaign against Israel, one that has resulted in the Israeli government evacuating 60,000 people from their homes in northern Israel. This situation was clearly intolerable to the Israelis and led many to suspect it would result in a war against Hezbollah, a war that we are now seeing the beginnings of.

Markets had been dismissing these risks for months. They had been banking on the idea that the conflict would remain contained. In effect, that means they had been relying on the assumption that Israel would merely continue its campaign against Hamas and would not expand the front to the north. However, Israel did open a northern front and, shortly after, we gained a sense of why this risked escalation to a regional war: in response to the assassination by Israel of Hezbollah leader Hassan Nasrallah, Iran – an ally of the group – launched a large missile strike against Israel in early October.

Unless one side backs down, the situation in the Middle East now looks ripe for continuous escalation, with one fighting force hitting the other, and the other responding in kind. It is no longer tenable for markets to ignore this risk, and since the Middle East is central to global energy markets, investors need to be realistic about the potential for another round of inflation driven by yet another energy shock. We are already starting to see price action in this direction in the oil market with the price for Brent having recently risen from a low of $70 a barrel in early September to $80 a barrel just after the Iranian strike – although it has since fallen back.

How important is the Middle East to global energy markets?

The region accounts for approximately 18% of global gas production. Since the outbreak of the Russia-Ukraine war and the consequent disruptions, this has made the region a more important player in the European liquefied natural gas (LNG) market. But it is still the production and export of crude oil where the Middle East excels: the region comprises 32% of global production and has 40% of the world’s proven oil reserves.

Five of the ten top oil producers are in the Middle East: Saudi Arabia, Iraq, Iran, the United Arab Emirates and Kuwait. What is more, these countries have a much larger impact on the global oil price than larger producers, like the US. The reason for this is that while the US produces large amounts of oil, it consumes even more. Middle Eastern countries, however, typically produce much more oil than they consume.

Even though the US is the largest oil producer in the world, its net oil output – oil production minus oil consumption – is around minus 6.7 million barrels per day, meaning the country runs a large crude oil deficit. Net oil production in Saudi Arabia, on the other hand, is 4.5 million barrels a day.

From “destabilising” to “catastrophic”

How might this oil production be affected by conflict in the Middle East? The scenarios here range from “destabilising” right up to “catastrophic”, depending on what takes place in the coming weeks and months. A destabilising series of events would unfold something like this: Israel would respond to Iran’s strike with a counterstrike on Iran’s energy infrastructure, which would in turn prompt Iran to respond to Israel.

This might then result in instability or strikes in other countries like Iraq and Syria. In this scenario, around 10.4% of global oil production would be at risk. Of course, not all 10.4% would be taken offline, but even if only a quarter of this output was removed from markets there could be a large impact on prices.

The nightmare scenario – the truly catastrophic event – would be if the strikes and counterstrikes eventually gave way to a regional war in the Middle East involving Israel, possibly the US, and Iran, plus its proxies in the region. If this war reached any serious level of intensity there is a serious risk that the Iranians would use anti-shipping ballistic missiles to blockade the Strait of Hormuz, much as the Houthis have recently blockaded the Red Sea entrance to the Suez Canal. Around 20%-30% of global oil production is shipped through the Strait of Hormuz and a closure, together with a regional war, could knock out a significant part of this capacity.

The last time we saw a significant hit to global oil production was after the Iranian Revolution in 1979 and the Iran-Iraq War that followed. Between 1979 and 1983 global oil production fell approximately 17%. As production started to crater, the markets priced it in quickly: between 1979 and 1980 the price of oil nearly tripled. We saw a similar move in the oil price in response to the oil embargo by Opec, the oil exporters’ cartel, against Western countries in 1973 after they backed Israel in its war with the Arab countries.

The impact on consumer prices

What would a tripling of the price of oil mean today? First, it would mean a rise in the oil price to around $210 a barrel. This would mean the most expensive oil the world has ever seen, at least in dollar terms; $210-a-barrel oil would be around 58% higher than the historic peak we have seen so far – $133 a barrel in the summer of 2008. Even if a major decline in oil output did not lead to shortages, it is inevitable that such high oil prices would lead to inflation.

The link between oil prices and inflation is quite firm, with oil price fluctuations often accounting for a good deal of the volatility we see in inflation. This allows us to model the impact that $210-a-barrel oil would have on the inflation rate. The result of this model is by no means perfect, but it is almost certain to be in the right ballpark.

$210-a-barrel oil means inflation of around 18% in the US and 19% in the UK. Despite the high and painful inflation of the past few years, we never saw the inflation rate break 10% in either country. If our model is in the right ballpark, a crisis in the Middle East would mean roughly double the inflation that we have seen over the past few years. The impact of such inflation on living standards in Western countries – already reeling from the last cost-of-living crisis – would be enormous.

Gauging the probabilities

What are the chances of this happening? It depends mostly on what the Israeli government chooses to do next. If it responds to the previous Iranian strike in a measured way, the situation might cool off – although even in this scenario, it is worth noting that while the conflict has ebbed and flowed over the past year, the general trend has been toward escalation. If Israel responds by hitting Iranian energy and nuclear facilities, then at the very least we will see the conflict spread across the region. Whether it becomes a regional war at that point likely hinges on what the US decides to do.

This is where the election comes in. In the run-up to the election itself, Joe Biden’s administration is likely to constrain itself – and its Israeli partners, as best it can. But after the election, it is anyone’s guess. If Donald Trump wins, for example, the Biden administration may give Israel the go-ahead to escalate knowing that the economic consequences will fall on the incoming Trump administration – a government generally seen as more favourable to Israel than the Biden administration. If Kamala Harris wins, it will be strongly in the Democrats’ interest to keep the situation from boiling over. Ultimately, however, trying to guess what the White House will do is as fruitless as the Kremlinology common in the Cold War period. We will just have to wait and see.

Black gold: hedging against inflation

What are investors to do? This is certainly one of those scenarios where there is little point in trying to predict the future. If an investor is concerned that their portfolio might experience a negative shock from such a global event, the ideal is to find a series of relatively cheap hedges that might offset this.

In this context “cheap” simply means assets that are not likely to fall too much if nothing happens in the Middle East. These assets provide significant upside risk in the case of chaos breaking out and minimal downside risk in the case where nothing happens.

The most obvious cheap asset in this regard is oil itself. Despite all the chaos, and even despite the upward moves in recent weeks, the price of oil is surprisingly low at present. The previous oil price shock had largely unwound by the start of 2023. Since then, the average price has been approximately $78 a barrel. Anything under $78 a barrel should be considered cheap. The longer-term average oil price since 2009 is around $71.50 a barrel and anything under this should be considered very cheap. Buying oil cheap minimises the downside risk of losing money if nothing happens.

Then there is gold. In contrast to oil, gold is not currently cheap. At close to $2,650 an ounce, gold is the most expensive that it has ever been. Yet there is good reason to think that the shiny metal is not in a bubble. Until quite recently the gold price could be shown to track inflation data quite reliably. But in the past few years, it has found a second driver: purchases by central banks. Rattled by the sanctions imposed on Russia’s dollar and euro foreign-exchange holdings after the war, central banks are rushing to buy gold, and this is driving the price up.

It seems reasonable to think that if the Middle East falls into chaos, central banks will double down on this bet. And if high oil prices feed into inflation, this could give gold a double boost. Purely based on price, gold does look very expensive – and investors should weigh this risk carefully. But the drivers of the price suggest that gold is on the up and up, regardless of what happens in the Middle East. Whereas buying oil now is like buying a stock with low multiples, opting for gold right now is like buying a popular growth stock with strong fundamentals.

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The US Federal Reserve has cut interest rates for the first time in more than four years, and signalled that more reductions will follow.

On Wednesday evening the Fed announced a cut of 50 basis points, leaving the federal funds rate at a range of 4.75 to 5%. After the announcement, policymakers at the central bank suggested rates would be cut by an additional 50 basis points before the year is out.

“The US economy is in a good place and our decision today is designed to keep it there,” Fed chair Jay Powell said at a news conference yesterday.

The reduction by the Fed follows cuts by other central banks, including those in Europe and Canada.

The cut came amid fears that the world's largest economy is flagging, with the unemployment rate in the US climbing to 4.2% from 3.7% at the start of the year.

Isaac Stell, investment manager at Wealth Club, says: “The Federal Reserve has entered the race at pace, opting for the jumbo option, cutting headline interest rates by 0.50%. 

"Despite there being no significant economic woes on the radar, policy makers have decided to get ahead of the curve as recent payroll reports have shown a gradual slowdown in the jobs market."

US stocks rallied immediately after the announcement and the FTSE 100 opened higher in London on Thursday morning as investors cheered Wednesday night’s cut.

What does the US interest rate cut mean for UK interest rates?

On Thursday the Bank of England announced its decision to keep interest rates on hold at 5% for at least the next two months. The decision is a blow for households and businesses struggling with high borrowing costs, but one that was widely expected.  

The decision from the Monetary Policy Committee (MPC) was clear-cut, with members voting to hold rates by an 8-1 majority. The only committee member who voted to reduce the base rate to 4.75% was Swati Dhingra, who has repeatedly advocated for a more dovish stance from the UK central bank. 

The decision to hold comes after interest rates were cut from their 16-year high of 5.25% on 1 August.

In its August policy summary, the MPC said: “Monetary policy will need to continue to remain restrictive for sufficiently long until the risks to inflation returning sustainably to the 2% target in the medium term have dissipated further.”

Since then, inflation has inched up to 2.2%, and services inflation and wage growth remain elevated at 5.6% and 5.1% respectively.

The next MPC meeting will not take place until November, at which point a rate cut looks more likely. Markets have been pricing in one to two more cuts before the end of the year, with November looking like the most likely month. 

And what does the US rate cut mean for markets?

Lower interest rates have the tendency to increase company share prices for a couple of reasons.

In the first instance, it allows firms to borrow cheaper debt, which it can then use to expand operations and hopefully make the business more profitable.

Secondly, in an environment of lower interest rates, putting your money into savings accounts becomes less attractive and so many investors instead move it into higher returning assets, such as stocks.

Gabriel McKeown, head of macroeconomics at Sad Rabbit Investments, says: "With the Fed making a clear statement that it's prioritising growth over inflation concerns, this could be the start of a new bull market in risk assets."

Investment platform Freetrade, known for letting users trade shares from their phone, has launched a collection of easy-access exchange traded funds (ETFs) that track the overnight interbank rate in the UK and US.

The Cash Investments ETFs seek to track or outperform overnight interbank interest rates and pass on any changes in the rate lenders are charging each other to investors. It also gives investors freedom to access their investments without a penalty. 

According to Freetrade, you could currently earn an expected rate of up to 5.33% which outperforms the top easy-access savings account on the market right now, which currently pays 5.22% via Metro Bank.

This is amid a string of base rate hikes in the UK and the Bank of England holding interest rates at 5.25% for a second month. The Fed rate currently stands between 5.25% and 5.5%. 

Find out how the Freetrade ETF range works and how it compares to rates on the savings market. 

How do the Freetrade ETFs work? 

Unlike traditional investments like stocks and real estate where you usually get better returns by investing for longer, these EFTs can help short - medium terms investors earn good returns with relatively low risk.

The funds track the Sterling Overnight Index Average (SONIA) in the UK and the Fed fund rate in the US, with an aim to pass on interest rate changes to investors overnight, rather than relying on a fund manager to pick investments, which Freetrade says makes it low risk.

“These funds offer investors greater flexibility than savings accounts and returns that track overnight lending rates, not the whims of banks,” says Alex Campbell, head of communications at Freetrade. 

The cash investments are also ISA and SIPP eligible, which means investors can protect their earnings from the tax man. Though it is worth noting that currently, you can only have one active stocks and shares ISA.

“Unlike savings accounts, these ETFs can be bought and sold during market opening hours, their returns track the latest benchmark rates set by central banks, and they can be held with cash already inside a tax wrapper,” Campbell adds. 

How do the ETFs compare to the savings market? 

The investments on offer are a mix of GBP and USD ETFs. 

The Fed Fund rate has a top expected rate of 5.33% which beats the UK base rate by 0.08% and it outperforms the 5.22% top easy access saver on the market right now by Metro Bank. 

However, the fund manufacturer still takes a fund fee of up to 0.15% which you will need to factor in. 

Fed fund rate ($SMTC) has the lowest fund fee out of all five ETFs on offer, at 0.09%, on a benchmark rate of 5.33%. In this case, the expected rate drops to 5.24%, which is still higher than what’s on offer in the easy access savings market. 

I can’t help thinking there are some real opportunities coming in the yen. The currency has been extremely weak for a long time. Against the US dollar, it is at lows not seen since before the turn of the century. 

We all know what a rotten currency the pound has been. Inflation has eroded a third of its purchasing power since 2020. A third! Against the constant that is gold, it has lost 90% of its purchasing power since 1999. And yet against the yen, the pound is at seven-year highs, not far off the levels seen before the global financial crisis in 2008. In those days a pound bought you two dollars, instead of the $1.21 it gets you today. 

In terms of trading volume, the yen is the third-most important currency in the world, after the dollar and the euro, accounting for around 17% of global daily foreign exchange (forex) turnover. As that is thought to total $7.5trn, we are talking about approximately $1.3trn of daily trading volume. No small beer. 

Why the yen is so weak

The main reason is that, while other central banks, especially the US Federal Reserve, have raised rates, the Bank of Japan (BoJ) has not. It has ignored rising inflation (perhaps because Japan has had trouble with deflation for so long). Indeed, the BoJ has been creating digital money and buying extraordinary amounts of government bonds with it to cap rates.

The BoJ now owns over half of the Japanese national debt. My mind boggles when I read statistics like that. How can it be possible to print so much money and buy so much debt without apparent consequence? This is the BoJ’s so-called yield curve control. I wish they’d print money and buy me a mansion, or even just a nice car.

Suppressed rates lead to the yen carry trade: borrowing yen at a cheap rate and holding other currencies that pay a better yield. But when the carry trade reverses, as in 2007-2008, it tends to reverse very quickly. This reinforces the yen’s tendency to act as a safe-haven currency: during times of panic, such as we saw in 2008, there is rapid flight to the yen in a rush to unwind the carry trade.

Looking at the long-term dollar-yen exchange rate, the dollar made its low, or the yen its high, depending on how you view things, in late 2011 and 2012. Since then the yen has halved; 50% declines for a major currency are eye-catching. There were also plenty of previous sharp declines. It slumped between 1990 and 1995, between 1998 and 1999, from 2007 to 2011 and in 2015-2016. When that thing moves, it moves.

I’m not going to pretend to be any kind of an expert on Japanese policy, plans or goals, but I ask, at a certain point, will the BoJ step in to shore up the currency? Surely it must. Everything I read tells me it will. If so, at what point?

The 150 yen to the dollar level is one commonly cited number. 150 is where we are now. But I stress this is only a rumour. Investors have inferred from the BoJ’s statement last week that intervention is not imminent and may not be as significant as many hope. Hence last week’s sell-off.

A related question is: how long will so-called yield curve control go on for? Again, I can’t pretend to know the answer. I am struggling to get my head around the fact that it has been able to go on at all, let alone for this long.

Sterling and yen: a volatile pair

In the meantime, consider another highly volatile currency pair: the yen and sterling. This is where I think the money is going to be made. Going back to 1991, the rate has ranged between 255 and 120 yen to the pound.

During the periods of a strong yen, sterling came down like a stone: between 1990 and 1995; from 1998 to 2000; in 2007-2008 and in 2015-2016. The financial crisis saw the pound drop all the way from 250 to 120 to the yen, a 52% plunge. 

These trends also tie in with my eight-year cycle of the pound: it is even more apparent when viewed in yen. As so much of the British economy is built on finance, sterling tends to be strong when financials are strong. It sells off during market panics, which is when money flees to the yen. Thus the pound and the yen are inversely correlated. 

Sterling has been weak against most currencies since the summer. Cable (the name given to the sterling-US dollar exchange rate) has gone from $1.31 to $1.21. The eight-year-cycle in the pound seems to be playing out again. But against the yen it has hardly moved. It’s the same price that it was in June and July, and has been gaining against the yen since Covid. Does this trend continue, or is it exhausted?

Most of the 2020 Covid trades (the boom in technology stocks, in commodities, in bitcoin) have played out and unwound. But not the decline of the yen. That is still going strong. There is some catch-up to be had.

When does it end? That’s the question. There may still be some gas in the tank, but I’m starting to think sooner rather than later – if only because so few people are talking about it. I recently asked three different finance WhatsApp chat groups that I’m on if anyone had any decent yen material. Nobody came back with anything. Such things are often a good, contrarian sign. Nobody rings a bell at the top of the market, unfortunately. But this is one to watch. 

Forex trading is extremely difficult. There is so much that can go wrong, especially to do with risk management, position sizing and timing. I don’t recommend it unless you know what you are doing. But I feel there could be an opportunity here.

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The interest rate hiking cycle has ended - or that’s what it looks like anyway following the latest decisions from the European Central Bank, Bank of England and Federal Reserve. 

In the past week, all of these central banks have announced they’re pausing one of the most aggressive rate hiking cycles in the history of independent central banks. The BoE’s monetary policy committee (MPC) held the base rate at 5.25% at their meeting yesterday, the second meeting they’ve kept rates constant. 

Only the day before, the US Federal Open Market Committee voted to keep rates on hold for the second time, at a 22-year high of 5.25-5.50% (unlike the BoE, the Fed sets a range for its Fed Funds rate). And last week, the ECB held rates at 4%. 

All three of these leading central banks have hiked rates from zero over the past 18 months, as they’ve tried to bring inflation under control.  

Inflation begins to fall  

So far, the medicine seems to be working. Eurozone inflation dropped to a two-year low in October of 2.9%, from 4.3% a month earlier. Meanwhile, inflation dropped to 3.7% in the US for the 12 months ended September. 

Here in the UK, inflation has proved tougher to control. Since CPI inflation reached 11.1% in October last year it has fallen by more than 4 percentage points, although it flatlined at 6.7% in September. Inflation has remained sticker in the UK due to the energy price cap, which works with a lag. 

Unlike the US and Eurozone, where lower energy prices have already filtered through to consumers and businesses, the price cap is preventing prices from falling as fast here in the UK.

As energy is a big component of the inflation figures, this is something policymakers will be taking into consideration when setting interest rates. 

Higher interest rates are starting to have an impact 

Inflation is just part of the equation for central bankers. While The Fed, BoE and ECB all have a mandate to keep inflation under control, they don’t want to crush their respective economies at the same time. So they have a tough balancing act to practise.

That said, coming off the pedal too early could reverse much of the progress they’ve already made in the fight against inflation. BoE governor Andrew Bailey has said rates must stay, “sufficiently restrictive for sufficiently long”. He’s also recently added, “It’s far too early to be thinking about rate cuts.” 

Across the pond, Fed chairman Jerome Powell has summarised the Fed’s stance as being “not confident we have reached sufficiently restrictive [financial conditions], but not confident we haven’t”.

The markets have a bit of a different view. The market is pricing in interest rate cuts starting in the second half of next year and is only assigning a slim chance to further rate increases from both the BoE and the Fed. 

There are signs on both sides of the pond higher rates are starting to have an impact on economic growth. In the UK in particular, activity in the construction sector has fallen off a cliff and consumers are pulling back on spending as higher interest rates bite. It’s also more appealing than it has been for over a decade to save rather than spend (one of the main reasons why interest rates are so effective at controlling prices). 

Higher interest rates mean it’s more expensive for companies and consumers to borrow money to spend and invest, which reduces demand, forcing businesses to lower their prices. While inflation remains high in the UK, shop price inflation has been falling, suggesting part of this equation is already playing out as businesses compete for customers’ shrinking spending power.  

An upcoming election  

The BoE will have this in mind when it’s thinking about interest rates going forward. If businesses have to fight for consumers' money, business activity in the economy will fall (as is already happening in the construction industry) and that could lead to a recession. Higher interest rates are already forcing the government, which relies of debt to fund the day-to-day running of essential services, to consider benefit and spending freezes. 

With an election coming up, the government may start putting pressure on the BoE to cut rates, or at least hold off on any further rate increases to avoid sending the economy into a recession or driving harsh spending cuts in 2024. 

All in all, there’s a chance the BoE could push rates higher in the coming months if inflation surprises to the upside, but with risks to the economy growing, and inflation falling in the rest of the world, (which will filter through to the UK over time) the central bank may decide to hold off on any further changes or even cut in 2024. 

The Bank of England has held interest rates at 5.25% for the second time in a row.

It was a widely expected move; money markets had placed a 92% chance that rates would be left unchanged.

September’s inflation figures, which revealed that inflation had stayed at 6.7%, took some pressure off the Monetary Policy Committee (MPC) ahead of its meeting.

The MPC voted by a majority of 6–3 to maintain the base rate at 5.25%. Three members preferred to increase the rate by 0.25 percentage points, to 5.5%. 

It means rates continue to be at a 15-year high.

The notes of the MPC meeting said there were “upside risks to inflation from energy prices given events in the Middle East. Taking account of this skew, the mean projection for CPI inflation is 2.2% and 1.9% at the two and three-year horizons respectively”.

It added: “Further tightening in monetary policy would be required if there were evidence of more persistent inflationary pressures."

By leaving rates unchanged while continuing to flag the possibility of further tightening to come, the Bank is indicating that it remains in “wait and see” mode. 

Governor Andrew Bailey also warned that it was "much too early to be thinking about rate cuts".

The Bank's actions follow the Fed’s decision yesterday: it held its key interest rate at 5.25%-5.5%, a 22-year high.

Homeowners will be breathing a sigh of relief that the relentless interest rate rises seem to have come to an end. The Bank of England has been hiking rates since December 2021. Two years ago, rates were just 0.1%.

Mortgage rates have soared to reflect the rising base rate, although many lenders have cut rates recently due to the base rate now being frozen. 

The average two-year mortgage rate is currently 6.3%, according to the analyst Moneyfacts. The average five-year fix is 5.87%.

WHAT IS THE OUTLOOK FOR INTEREST RATES? 

Many experts believe we have now reached the top of the rate rise cycle.

The consultancy Capital Economics expects the base rate to stay on hold at 5.25% until next November. 

Paul Dales, chief UK economist at the consultancy, comments: “By leaving rates at their 15-year high of 5.25% for the second time in a row, the Bank all-but confirmed that rates have peaked." He also highlights that it was a 6-3 MPC vote compared to the 5-4 vote in September, with three rather than four MPC members preferring a rise in rates to 5.5%.

Dales adds: "We think the economy will be weaker than the Bank expects over the next six months (a mild recession may already be underway), which will sow the seeds for a sharp fall in core inflation and wage growth in late 2024 and in 2025. That’s why we expect interest rates will be cut all the way to 3% in 2025 rather than to the 4.25-4.5% implied by market pricing."

The Bank of England's November Monetary Policy Report, released at the same time as today's interest rate announcement, notes that the base rate has a "market-implied path that remains around 5.25% until Q3 2024 and then declines gradually to 4.25% by the end of 2026, a lower profile than underpinned the August projections".

Colleen McHugh, chief investment officer at the investment platform Wealthify, comments: “Although we may be at the peak of interest rates in this rate cycle, discussions about further tightening are likely to persist, given uncomfortably high services inflation. Indeed, it was made pretty clear today that interest rate levels are going to remain in place for ‘an extended period’. Gilt yields fell back marginally in relief with the pause, with sterling fairly muted.”

There is one more interest rate announcement to come this year, on 14 December.

For all the dates of next year’s MPC meetings, read Key dates for 2024: here are the dates you need to know when managing your money. 

WHAT DOES A RATE FREEZE MEAN FOR HOMEOWNERS?

First-time buyers, homeowners on variable or tracker mortgage deals, and those about to remortgage will be happy that interest rates have not been hiked today. About 2.2 million homeowners are on variable-rate mortgages.

Fixed mortgage rates have already been falling. According to Katie Brain, consumer banking expert at data firm Defaqto, the best two-year fixed rates have dropped by 0.83 percentage points over the past two months. And there are now more five-year fixed-rate deals below 5%. 

“Hopefully this means the mortgage market is starting to stabilise a bit, especially with Nationwide reporting that house prices have begun to slightly rise too,” she comments.

Those on a standard variable rate (SVRs) will still be facing sky-high mortgage costs. These are the most expensive mortgages; homeowners who do not take out a new deal at the end of their tracker or fixed mortgage automatically move onto their lender’s SVR. 

The average SVR has rocketed from 4.41% two years ago to 8.19% today, according to Moneyfacts. 

If you’re on an SVR, contact your lender or mortgage broker to discuss your options and find out if you can switch to a cheaper rate.

Homeowners taking out a new mortgage or remortgaging might be considering opting for a tracker deal now, in the hope the Bank of England cuts rates more rapidly than expected and they enjoy falling mortgage costs. 

However, Laura Suter, head of personal finance at the investment platform AJ Bell, points out: “What the past few years have taught us is the economy and its outlook can change rapidly, so tread with caution when betting a huge financial decision on current expectations.

“Tracker mortgages can be a great option if you want more flexibility, know that you might want to get out of the mortgage sooner or want to overpay by more than the usual limits. But if another interest rate hike would take you beyond your affordability limits, picking a fixed-rate deal might be better for you. Just because rates are not expected to rise further, things can change and it isn’t a cast-iron guarantee.”

WHAT DOES THE RATE FREEZE MEAN FOR SAVERS?

Savers are enjoying the highest rates in 15 years. A handful of easy-access savings accounts are paying above 5%, while you can get more than 6% on a one-year fixed account and 8% on the best regular saver account.

However, the interest rates on some fixed-rate savings accounts have been falling recently, and some providers have even withdrawn their top deals.

So, if you spot a savings account you like the look of, you may need to act quickly to secure it.

“The news for anyone who has been waiting on the sidelines for even higher rates is: act now while stocks last,” notes Suter. 

“The same is true for those wanting to get a good easy-access account. While the rates are variable and could be cut at any time, it’s a good idea to nab the top deal now rather than holding out for a huge increase. The reality is while there may be some very small increases in savings rates, the general trend is going to be for a plateau and then fall.”

Stephen Sillars, savings and investment editor at wealth app Chip, stresses that "no action from the Bank of England doesn’t mean savers should fall victim to inertia", adding: "Interest rates on savings have risen throughout the year, so it’s important to make sure your bank hasn’t left you behind."

MoneyWeek Editor, Andrew VanSickle and James Montier, a member of the asset allocation team at investment management group GMO, discuss inflation, slow-burn Minsky moments and cheap investments.

Andrew VanSickle: Most analyses of the big picture start with inflation. We know that like us, you have always been sceptical of central banks, so we were intrigued a couple of years ago to see that you thought the US Federal Reserve was broadly right in its inflation outlook: that it would subside rather than become ingrained. Do you feel you got that right?
James Montier: Yes, I think so. US inflation has come down fairly rapidly from its peak. The supply constraints that had underpinned the price rises have eased. Thanks to energy prices there has been a slight uptick in inflation recently, but there has been no evidence of a significant swing towards workers’ bargaining power. So a wage-price spiral fuelling sustained inflation seems unlikely. The UK is harder to assess in this regard – we have probably had more evidence of wages potentially bolstering prices. Britain has always had a lot of imported inflation from sterling being weak, so the Bank of England’s job has been considerably harder than the Fed’s. 

Andrew: We’ve been struck by the fact that core inflation seems more entrenched in the eurozone and Britain, so there may well be scope for inflation to take hold. Gold is traditionally seen as a store of value and an inflation hedge, but we gather you’re not a fan.
James: The problem for me is that as I am a value investor, I have trouble working out how to value gold – whether I am paying a high or a low price for the insurance it may offer. I can’t gauge what is already in the price: as with all commodities, there are no cash flows attached to it. It is ultimately only worth what someone else is willing to pay for it. To my mind, if you want a long-term store of value, you need value stocks. Value stocks do not correlate with the ups and downs of inflation in the short term, so they’re not a good hedge in that sense. But their cash flows are essentially insulated against inflation. 

Andrew: The idea being they are often the kind of solid, defensive company in a position to raise prices along with inflation?
James: Yes. If we think of wage-price spirals as the key transmission mechanism for inflation, companies span both sides of that equation. They pay the wages, but they are also the ones charging the prices. So they can insulate your portfolio from price rises. They are a form of cheap insurance in this context. 

Andrew: Was that true during the last inflationary era, too? Commodity stocks did especially well then, didn’t they – is that because they tend to be value stocks?
James: Yes, that’s right. People often go and buy commodity stocks thinking that commodities are a hedge against inflation. But a look at commodity prices paints a very different picture. Some commodities do very well: oil in the 1970s, for instance. It was the source, or at least the proximate source, of some of the inflation. So oil equities flourished. But a bunch of other commodities did appallingly badly. Yet the stocks based on the commodities thrived. It was because the stocks were cheap and represented good value that they proved a good investment, not because they were commodity stocks. So if you are worried about inflation and looking for a store of value, look for cheap equities. 

Andrew: Turning now to the world economy more generally, what is your key worry
James: I think the global economy looks vulnerable to what I term “slow-burn Minsky moments”. 

Andrew: Named after Hyman Minsky, the economist who said stability breeds instability.
James: The trouble is that we have built up huge levels of private-sector debt in the world. These buildups sometimes occur through high rates of credit growth, giving rise to credit bubbles, but often they sit simmering in the background, largely unnoticed until the proverbial hits the fan. When that happens, the structural vulnerability created by the debt amplifies an economic and market downturn. 

High private debt has been a worrying feature of the world economy for a good 20 years now – in the US, household and non-financial corporate debt are jointly equivalent to 150% of GDP, for instance. Britain’s private-debt ratio is similar, while France's is 230%. Australia is on 180% and emerging markets on about 150%. The high private debt levels are an important reason why, for the last 20 years, we seem to have been living in an era of rolling financial crises. 

So the upshot is that the economy is on shaky foundations. Think of a house built on quicksand. Your house might be there for a while, but it probably won’t be there for the long term. The difficulty is that you can’t predict what the proximate trigger for the crisis will be; the fact that we have this vulnerability sitting in the background is the issue. More broadly, however, having high levels of private debt means we need the cash flows to keep servicing them, and anything that hits those cash flows becomes a problem. That’s why recessions are a big danger when you have this precarious foundation. 

It’s also worth bearing in mind that soft landings are as rare as hens’ teeth. Now here again value investing makes sense because in value investing we are used to dealing with uncertain timing. There is no rule that says cheap stocks can’t get cheaper and expensive ones more expensive, so you cannot know when your investment might pay off. So in a value framework, we insist on what Benjamin Graham used to refer to as a margin of safety. You want to make sure you have enough wiggle room in your purchase price to account for things that can go wrong. That makes sense in the context of these Minsky moments, too; you never know exactly when things are going to go wrong. The value-based approach makes for an interesting framework for thinking about how you protect a portfolio. As the Athenian general Pericles noted, you can’t predict but you can prepare. 

Andrew: So again, we have value investing as a form of insurance: if you have that margin of safety, you’re guarding against potential problems.
James: Yes. Remember financial author Elroy Dimson’s definition of risk, which is that more things can happen than will happen. This touches on an important point. History seems strangely linear, predictable and obvious looking back. Only certain things happened. But at the time there was massive uncertainty and so many different paths we could have taken. So building a robust portfolio that can survive different outcomes is important. 

Andrew: Coming now to where investors should be looking, we know that if you buy when something is attractively valued you should be able to enjoy much better long-term returns than if it is pricey.
James: Yes, and that’s very easy to lose sight of. Because the times when things are really cheap are often the times when people don’t want to invest. 

Andrew: What has been catching your eye?
James: The overall US market looks obscenely overvalued. If you look at the Shiller price/earnings (p/e) ratio (the cyclically adjusted p/e, which uses ten years of earnings to smooth out the profit cycle), it is around 30. But drill down and you find that value stocks are on a large discount to growth ones. They cost 18 times earnings, and growth stocks are on around 45. And “deep value”, the cheapest 20% of the market, looks absolutely bombed out, using a composite valuation measure developed by GMO. 

In the rest of the world, deep value is also extremely cheap. Value looks appealing compared with growth in Europe, Japan, and emerging markets, too: the Shiller p/es are around 12, 18, and seven respectively. Emerging value seems to be the world’s cheapest asset. We like it because it is being shunned. At this valuation, an awful lot of potential bad news has been factored into the price. It looks cheap enough to be able to generate annual returns of 6% in real terms over the next few years. You can also make a similar case for European value stocks. 

Meanwhile, Japanese value looks really interesting. Japanese stocks have witnessed a substantial change in their profitability, but that hasn’t been discounted by the market. And a cheap currency adds to the investment case. So however scary the global outlook, value stocks are providing a huge margin of safety for investors. Things will go wrong, but the risk of losing money and never being able to get it back is much lower if you buy cheap. This situation is an interesting contrast to 2012. Back then, we couldn’t find anything we liked at all: assets had been priced for perfection as everyone thought low interest rates would last forever.

US inflation rose to 3.7% in August, driven by a sharp increase in energy prices and higher costs for rent.

The US inflation rate was 3.7% over the 12 months to August, the Labor Department said - up from 3.2% in July.

The year-over-year increase was slightly higher than economist forecasts of a 3.6% annual jump.

The price of energy commodities, including gas and oil, jumped up 10.5% over the last month. 

 Will the Fed raise interest rates? 

Despite the surprise inflation  rise, analysts do not expect the figures to complicate matters for the Federal Reserve as policymakers tend to focus on core inflation numbers, which strip out volatile food and energy prices.

“Inflation data from the US yesterday was mixed but there wasn’t anything in there to cause major alarm for either investors or the Federal Reserve, even if energy prices are starting to become a relevant inflationary pressure again,” says Russ Mould, AJ Bell’s investment director.

On a core basis, prices in August climbed 4.3% over last year — a slowdown from the 4.7% annual increase seen in July.

Within core inflation, rent prices surged. The index for rent and owners' equivalent rose 0.5% and 0.4% on a monthly basis, respectively. Owners' equivalent rent is the hypothetical rent a homeowner would pay.

"If you look at what’s going on underneath the surface, core inflation continues to gradually cool," says David Kelly, chief global strategist for J.P. Morgan Asset Management. "I don’t think people should look at it as some kind of revival of inflation pressure."

The data is unlikely to make the Federal Reserve raise interest rates at its next meeting but it could push it to act later in the year, says Jeffrey Cleveland, chief economist at Payden & Rygel.

Seema Shah, chief global strategist at Principal Asset Management, believes one more rate hike is still possible before the end of the year.

"The inflation print likely is not enough to tilt next week’s Fed call towards a hike, yet it also hasn’t entirely cleared up the question of a November pause vs. hike,” she says.

 What is the current interest rate in the US? 

The Fed has already raised its benchmark interest rate to the highest level in 22 years, targeting a range of 5.25% to 5.5%.

The Fed rate is a range because the Federal Reserve cannot mandate a set number.

Fed chairman Jerome Powell warned last August that inflation remained “too high".

"We are prepared to raise rates further if appropriate, and intend to hold policy at a restrictive level until we are confident that inflation is moving sustainably down toward our objective," he said.

Like the Bank of England, the US Federal Reserve has a mandate to keep inflation at 2%.

The US central bank will meet to decide whether to or not to keep the rates unchanged at its September 20th policy meeting. 

Over the past decade, the two-year yield on government securities, otherwise known as gilts, has hardly been worth writing about. However, as interest rates have risen, even mass-market news websites such as the BBC have started covering gilt yields, largely as a proxy for mortgage rates.

The current broad two-year gilt rate is running at 5.14% whereas, for much of the last decade, it was slumbering under 1% and I’d argue there’s a good chance it could go much higher. 

There’s a perfectly respectable – even consensus – argument that the Bank of England (BoE) was complacent in the early days of rising inflation. It didn’t react with the same fortitude and determination as the US Federal Reserve and when it did start increasing rates, the steps were incremental and frankly a bit plodding: plenty of sensible 25 basis point increases. Now the genie is out of the bottle and inflation is clearly a problem. 

The BoE gets tougher 

Whatever view you take of the inflation debate it's now obvious that the BoE feels like it needs to be tougher and is signalling more increases. For its part, the market is projecting rates could hit 6.25% at the peak of the cycle (likely towards the end of the year). A peak rate of 5.5% or more seemed outlandish only a few months ago, whereas now it seems conservative. 

There are both active and passive gilt funds available for investors to buy. The active fund with the most exposure to short-dated paper is the Royal London’s Short Duration Gilts fund, with virtually all of its assets invested in bonds maturing in the next four years. Its largest holding, making up 27% of assets, matures in 2025. It has an ongoing charges figure of 0.29%. 

The biggest passive funds in the space are ETFs run by the fund giant iShares. iShares II Plc Core UK Gilts (IGLT) owns maturities ranging up to 10 years. These long maturity gilts are much more sensitive to changing rate expectations and thus much more volatile. By contrast, the iShares III Plc UK GILTS 0-5yr (IGLS) focuses – like the Royal London fund – on zero-to-five-year durations (as its name suggests) via 17 individual gilts. Charges are very competitive at 0.07%. The average asset-weighted yield to maturity is currently running at 4.4% with a weighted average maturity of 2.3 years. 

Both the active and passive funds I’ve mentioned could be seen as what I call money market plus accounts – they are similar to money market funds but with more fund price volatility. 

Crucially, if gilt yields do rise – as I think is possible – then we might see more downwards price pressure on the value of these funds even as yields increase (gilt prices move inversely to yields).

Money market options 

Money market funds are another option for investors who want to earn a higher return on their cash. 

These funds generally buy very short-dated paper, which is more akin to cash than bonds with the goal of tracking prevailing interest rates. Unlike the gilt funds, which own gilts backed by the government, these funds own a mix of paper, including UK Treasury bills as well as corporate debt. Vanguard’s Sterling Short-Term Money Market Fund has a weighted average maturity of 32.6 days and a yield to maturity of 4.6%. The ongoing charge is 0.12%. 

Another option is Royal London’s Short Term Money Market fund. With an ongoing charge of 0.1% it’s cheaper than Vanguard’s offering and has £5b plus of assets, compared to £335m for Vanguard. 

In the first of a new series of interviews, Andrew Van Sickle talks to Bill Dinning, chief investment officer of Waverton Investment Management, to assess the outlook for the global economy and markets.

Andrew: Let’s start with the macroeconomic environment. What is your assessment of the banking crisis that kicked off in March and its likely impact?

Bill: We think a systemic banking crisis in America is unlikely. Bank deposits are declining, but as far as we are concerned, instead of a panic this reflects the fact that banks have been very slow to raise the interest rates on savings accounts. Savers are heading to money-market funds or lending to the government for a better rate.

Note that the last time bank deposits (which usually trend upwards with GDP and income, so they tend to rise year on year) fell on an annual basis was 1994, when the Fed was also tightening. What’s more, regulators have erected a strong safety net. Instead of having to sell assets at distressed valuations, the US Federal Reserve will lend money relative to the par value of eligible assets. So there really shouldn’t be a panic here.

Andrew: Can we conclude that tighter credit will bring forward the recession that everyone’s been talking about, but never quite seems to arrive?

Bill: A lot of leading indicators have been pointing to a significant slowdown following all the rate hikes, and if credit is now rationed even more following the banking crisis, that could accelerate or exacerbate the downturn.

For instance, the National Federation of Independent Businesses regularly asks its members, who are small businesses, if it is a good time to expand their operations. In March, 2% thought it was (that was the lowest reading since 1980), and in April the figure was 3%. That question usually produces a score ranging from 1% to 35% and has been conducted since the 1970s.

Similarly, the Index of Leading Indicators and the New York Federal Reserve Recession Probability Indicator (based on the spread between three-month and ten-year Treasury rates), both reliable harbingers of an economic contraction since the 1970s, have been flashing red.

Andrew: What might this mean for US-led global stocks?

Bill: As far as markets are concerned, it’s interesting to note that the US bond market appears to be factoring in a significant slowdown, but equities aren’t. Cheerful equity investors are looking forward to interest-rate cuts (and a lower discount rate, bolstering the value of future earnings and hence valuations).

But they are forgetting that the cuts being factored in from the middle of this year by the Implied US Fed Funds rate curve would constitute the sort of monetary response likely in a recession – with the labour market unravelling and unemployed consumers reining in spending – and the stockmarket does not go up in recessions.

More broadly, Waverton is underweight equities thanks to the threat to earnings in the macro scenario we think is likely to unfold. But we are not massively bearish, as sentiment is fairly pessimistic, and relatively appealing valuations seem to suggest that some scepticism has been baked into earnings estimates: US profits are expected to grow by 1% this year, and global ones 0.9%. That is not a sign of euphoria.

Meanwhile, a widely watched survey, the American Association of Individual Investors’ Investor Sentiment Survey, tells an interesting tale. The percentage of investors who are bullish is a standard deviation below average.

Historically if you buy at these low levels of bullishness you get a double-digit return over the next 12 months. The widely quoted Bank of America Merrill Lynch global fund managers’ survey, incidentally, I pay less attention to as I find it backward-looking. They get more bearish as stocks go down.

Andrew: Shall we take a closer look at valuations?

Bill: Valuations, overall, are reasonable. The MSCI US index is on a forward price/earnings (p/e) ratio of 18.4, compared with a 20-year average of 16.4. But the world ex-US is on a multiple of 13, less than its 20-year average of 14.1. And if you strip out the top ten stocks from the US index, the market is not far off that.

These factors could temper a market downturn, while a broader positive scenario goes as follows. Inflation dissipates as expected, central banks lower interest rates, and later this year investors start to look through the slide and price in a recovery.

So there could be a relatively short shaky period before a market rebound. And in a cyclical economic upturn, Europe, Japan and emerging markets tend to outstrip the US.

Andrew: The outlook for inflation is pivotal. Shall we assess the UK now in the inflation and market context?

Bill: Markets think the Fed is finished hiking, but the Bank of England isn’t. If the market is right about the Fed cutting, the notion that the Bank of England will keep hiking could prove a bit too pessimistic.

There is clearly an inflation problem here, but I doubt whether raising British interest rates further will have much impact. The inflation impulse in the US certainly appears to be slowing, and there is no inflation in China. So if inflationary pressure is abating globally, then at some stage that should help out Britain.

Andrew: So you think inflation is an externally-driven phenomenon.

Bill: Well, I think curbing domestic demand in Britain will have some effect, but it’s hardly on the same scale as curbing the Goliath that is the US consumer. American household spending comprises 70% of the biggest economy in the world. So if the Fed can temper that, there will be a worldwide impact.

The upshot of all this is that we are still overweight UK equities, which remain cheap compared with the rest of the world. The UK MSCI index is on a forward p/e of 10.6, while the MSCI World index costs 15.6 times the next 12 months’ profits. So the British stockmarket is on a 30% discount. What’s more, the defensive nature of the market suggests that it should prove resilient in a downturn, too, as was the case with blue chips last year.

Andrew: Assuming now that inflation doesn’t dissipate as everyone seems to hope, which is MoneyWeek’s key fear, where should investors look?

Bill: If the news on inflation is worse than the market expects, then raw materials are among the few assets where you can find some protection. Gold is still attractive, we feel, even if it is at near-record highs in dollars and sterling.

The overall commodity complex is appealingly valued compared with stocks, and is also a good structural and cyclical growth story. Turning to valuations first, a chart mapping the ratio of the Goldman Sachs Commodity index to the Dow Jones index shows that commodities remain depressed on a historic view.

It is also striking that Apple’s market value will buy you the world’s top 100 miners, three years’ global copper-mine production and last year’s seaborne iron ore – quite a haul. The top-ten miners, moreover, should generate $99bn of free cash flow over the next 12 months, compared with Apple’s $94bn. But the miners are trading at just nine times forward free cash flow, compared with Apple’s 25.

There is plenty of cyclical impetus, too – $2trn is being spent on infrastructure in the US, while governments around the world are upping spending on renewable energy to combat climate change.

Longer-term, new technologies such as electric- vehicles and 3D printing look likely to compound the impact of the climate-change drive and underpin structural growth. Investors can play the theme with the Global X Disruptive Materials UCITS ETF (LSE: DMAT), tracking firms offering metals that are crucial to disruptive technologies, ranging from lithium batteries and solar panels to fuel cells and robotics. On the energy front – we will need fossil fuels to get us to net-zero – Waverton holds Shell (LSE: SHEL) and oilfield services giant Schlumberger (NYSE: SLB).

Andrew: Finally, returning now to the global picture, the past few years have taught us to keep an eye on geopolitics and its ramifications. The one disaster everyone worries about is China invading Taiwan. Is that likely, do you think?

Bill: I don���t think so. The practical difficulties are immense. Only 10% of Taiwan’s coastline is suitable for an amphibious landing. The Germans didn’t have drones and radar that worked in 1944 when the Allies landed on the beaches and didn’t know where we would attack; today Taiwan would be ready and waiting. It would be a bloodbath.

Moreover, the People’s Liberation Army (PLA) is not one of the world’s best armies. It has kept the Communists in power, but their last military campaign outside China was not a success; they merely achieved a stalemate against Vietnam in 1979. The PLA is large and unwieldy. Once you employ well over one million people, it becomes very hard to be efficient.

As for the Ukraine conflict, the only good news is that all the horror scenarios discussed last year, such as running out of gas, have not come to pass. Unless there is a major escalation, it should not move markets.

More from MoneyWeek:

• Britain is in the bargain basement: buy small- and mid-caps for the bounce
• Lloyd’s of London: Invest in the DNA of global capitalism
• Adidas still has a lot to prove
• Could these 5 collectables make you rich

• China’s reopening has delivered a timely boost to Asia’s economies and financial markets
• Asian exposure needs to weather near-term risks, while also focusing on long-term secular trends
• Dividend investing in Asia does not necessarily come at the expense of growth

China’s reopening has reversed a significant period of weakness for Chinese stock markets and renewed enthusiasm for the Asian region more widely. Amid this environment of greater confidence, is an income strategy the right way to harness opportunities in Asia?

As economic activity resumes with China’s reopening, there are multiple beneficiaries: from the pandemic laggards, such as travel and leisure companies, to consumption related industries, which are benefiting from reviving consumer confidence. The positive effects have spilled over to the export-oriented markets of Taiwan and South Korea, while tourists are also beginning to return to popular destinations such as Thailand.

This underlines China’s pivotal role in Asia’s economic recovery, and its reopening bodes well for the region’s prospects in 2023. In addition, inflationary pressures are not as acute in Asia as in the West. This gives Asian companies a notable advantage and resilience over their Western peers, which are facing rising costs and labour difficulties.

While the operating environment appears to be changing for the better in Asia, investors would also need to consider potential near-term risks. Recovery within China is unlikely to be a straight line, albeit we expect domestic consumption to underpin economic growth this year as the country reaches herd immunity fast. The real estate market is stabilising, and we are monitoring domestic sentiment which, in turn, depends on buyers’ confidence in an economic recovery.

Broader inflation and interest rate concerns are still very real. Persistent inflation and a strong labour market are giving the US Federal Reserve pause for thought when it comes to moderating or ending its cycle of interest rate increases. The global economy remains fragile with recession risks in Europe and the US, while geopolitical tensions could also act as a break on Chinese growth.

More recently, banking turmoil in the US and Europe has caused jitters across markets because of concerns that this could result in tightening funding conditions and potential regulatory squeeze, which in turn, could hurt asset quality, the growth recovery and capital flows in the Asia Pacific. The question is what next and this is why we have always backed the banks that are well-capitalised, well-funded, have conservative underwriting and treasury management, and have not taken unnecessary risks to grow. Our bank holdings may even benefit from a flight to quality for both deposits and maybe even wealth management flows in the case of the Singapore banks.

Against this backdrop, we believe it is vital to position Asian exposure to weather near-term risks, and we believe that a portfolio of quality holdings with sustainable competitive advantages and robust balance sheets, which are less reliant on debt financing and continue to display financial strength, will protect their margins and dividends better even in the face of persistent inflation and a higher rate environment.

Over the longer term, investors should also focus on the long-term secular trends playing out across Asia, such as huge consumer markets, technology and green energy. The region also has favourable population demographics. These themes are creating opportunities in areas such as digitalisation, healthcare and wealth management.

Income and growth

Unlike in some Western markets, dividend investing in Asia does not necessarily come at the expense of growth. Many Asian companies pay stable dividends while also growing at a decent pace. Equally, income investors are not confined to low growth sectors. For example, the Abrdn Asian Income Fund has a high weighting in information technology stocks, focusing on areas such as hardware, semiconductors and foundry companies. The trust holds companies with strong balance sheets that are also growing their revenues and dividend payouts over time.

In Asia, dividend contribution has been on a steady upward path, helped by greater capital discipline and shareholder-friendly reforms. It now comprises close to half of total returns to shareholders. 2022 was a bumper year for dividends globally, but particularly so in Asia. The MSCI AC Asia Pacific ex Japan Index had a dividend payout ratio of 45% and a gross aggregate dividend yield of 3.4% as of end-December 2022, trumping most other major global markets on both metrics. On the trust, we increased the dividend by 7.5%, a 14th year-on-year increase, giving investors a significant head-start in outpacing inflation.

Valuations remain reasonable across Asian markets, while earnings have been at cyclical lows and look set to recover. There is still abundant choice of businesses that generate good profitability and cash flow and pay higher than the benchmark dividend. At the same time, their strong balance sheets should provide some defensiveness if the reopening trade proves bumpier than expected.

Portfolio in action

This balance of leaning into the recovery while managing potential risks is in evidence throughout the portfolio. The trust holds an overweight to Singapore, for example, because it provides a quality screen in accessing growth in markets such as Malaysia, Indonesia, Thailand and even China. The big banks in Singapore, such as OCBC, have exposure to China’s burgeoning small and medium-sized enterprises (SME) sector. The consumer-oriented and tech-linked names that we hold are hitched to secular themes, including e-commerce and technological development.

Our tech hardware and semiconductor holdings in TSMC and Samsung are the two largest positions for the trust. The dividend yield for both looks quite low, but these companies have grown their dividends per share on a dollar basis and follow a dividend pay-out policy that is linked to their free cash flow generation. Looking ahead, earnings growth for these market leaders looks well supported as prospects for high-power computing, data centres and servers remain compelling, while AI complexity would boost semiconductor demand and overall market expansion.

‘Going green’ is a strong theme across the portfolio, with significant government support for the renewable energy transition across Asia. Among the trust’s holdings here, electric vehicle (EV) battery manufacturer LG Chem has a cash generative chemicals business that provides funding for new investments and R&D in the energy storage space. LG Chem is now one of the top five EV battery players globally. PowerGrid – the national grid of India – is spending at least 20% of its capital expenditure on renewable energy sources, while also paying a compelling yield.

The opportunities from the reopening of China – and its impact across Asia – can be harnessed effectively through a dividend strategy, which may also provide greater protection against some of the risks. There is growth opportunity in income strategies in Asia and dividends have proved extremely resilient through the economic turbulence of recent years. Investors could be missing out if they focus only on growth strategies to participate in the region’s recovery.

Companies selected for illustrative purposes only to demonstrate the investment management style described herein, and not as an investment recommendation or indication of performance.

Important information

Risk factors you should consider prior to investing:

• The value of investments, and the income from them, can go down as well as up and investors may get back less than the amount invested.
• Past performance is not a guide to future results.
• Investment in the Company may not be appropriate for investors who plan to withdraw their money within 5 years.
• The Company may borrow to finance further investment (gearing). The use of gearing is likely to lead to volatility in the Net Asset Value (NAV) meaning that any movement in the value of the company’s assets will result in a magnified movement in the NAV.
• The Company may accumulate investment positions which represent more than normal trading volumes which may make it difficult to realise investments and may lead to volatility in the market price of the Company’s shares.
• The Company may charge expenses to capital which may erode the capital value of the investment.
• Movements in exchange rates will impact on both the level of income received and the capital value of your investment.
• There is no guarantee that the market price of the Company’s shares will fully reflect their underlying Net Asset Value.
• As with all stock exchange investments the value of the Company’s shares purchased will immediately fall by the difference between the buying and selling prices, the bid-offer spread. If trading volumes fall, the bid-offer spread can widen.
• The Company invests in emerging markets which tend to be more volatile than mature markets and the value of your investment could move sharply up or down.
• Yields are estimated figures and may fluctuate, there are no guarantees that future dividends will match or exceed historic dividends and certain investors may be subject to further tax on dividends.
• Derivatives may be used, subject to restrictions set out for the Company, in order to manage risk and generate income. The market in derivatives can be volatile and there is a higher than average risk of loss.

Other important information:

Issued by abrdn Capital International Limited, registered in Jersey (38918) at 1st Floor, Sir Walter Raleigh House, 48-50 Esplanade, St Helier, Jersey JE2 3QB. abrdn Capital International Limited is regulated by the Jersey Financial Services Commission under the Financial Services (Jersey) Law 1998 (as amended) for the conduct of investment business and fund services business. abrdn Asia Limited, registered in the Republic of Singapore, Registration Number 199105448E.

Find out more at www.asian-income.co.uk or by registering for updates. You can also follow us on social media: Twitter and LinkedIn.

1

CLSA, Factset, 31 December 2022

2

Bloomberg, 8 March 2023

America’s debt ceiling debate shows we have reached a turning point. Trouble is, the authorities may not turn. They need to turn away from moneyprinting, deficits and expensive overseas meddling. Typically, the ruling class can’t do it.

These things increase their wealth and power; they don’t want to give them up. Instead, they use tricks, disguises and brute force to keep the racket going, all the way to the disastrous end. Will this time be different?

In the boom of 2009-2022, anything seemed possible. Money grew on trees. And the trees all got the Fed’s MiracleGro. It could be used to pay for pointless wars, investments that didn’t pay off, deficits, zombies – you name it.

No more. Inflation changes everything. It raises prices. And higher prices make consumers unhappy and voters restless. The social fabric wrinkles... then rips.

The middle class bears the brunt. The poor have their inflation-adjusted handouts. The rich have their inflationboosted financial assets. The middle class has neither.

All it has is its time – which it sells by the hour. Inflation depreciates time. Long-term investments aren’t made. Long-term bonds get marked down. And real wages per hour have been falling for the last two years.

Meanwhile, inflation increases house prices. But a home is not a financial asset. Families can’t “cash out”; they have to live somewhere. All they can do is borrow against the “equity”.

And then they are trapped; they will need low interest rates to refinance – or lose their homes. In countries with severe inflation, the middle class gets squeezed so hard it vanishes.

In Venezuela, Argentina, Zimbabwe... as inflation rates went up, the middle class sank into poverty. That’s why democracy is incompatible with inflation.

The many poor are dependent on government handouts; they are easily bamboozled and bribed. And the elite get to be good at it. They become “extractive” – that is, they use their skills and power to make themselves rich at others’ expense.

An honest democracy needs a free, informed middle class. It needs a yeoman class – people who own their own farms and houses, pay the taxes, are ready to protect the homeland, and vote independently.

But what’s happening? Middle-class Americans remain the biggest income group by number of people, says Statista; but the same can’t be said of its income. From 1970 to 2021, the share of US aggregate income earned by the middle class shrank from 62% to 42%.

Over the same time, aggregate earnings by high-income Americans rose from 29% to 50%. The disappearance of the middle class corresponds with another of the great conceits we can no longer afford: an empire.

Almost two decades ago, we wrote a book with Addison Wiggin called Empire of Debt. It was a best-seller, written in 2005 when US debt was $13trn or 60% of GDP. Today, it’s $32trn, 120% of GDP.

The gist of our book is that though the US has been in the empire racket for more than a 100 years, it has never gotten the hang of it.

It extends its power and it offers protection to nations who obey, but war and sanctions to those who don’t. The trouble is, it loses the wars and loses money on the whole enterprise.

The idea of an empire is that you conquer and steal, and then demand tribute. It’s supposed to be at least self-financing, and usually profitable.

But the US stumbles and bumbles. It has the expense of conquering, then the expense of governing, and the extra cost of “building a democracy”. But where’s the pay-off? The booty? The tribute?

The Bank of England (BoE) raised its base rate by 0.25% to 4.5% - its 12th consecutive hike as it continues to grapple with stubborn inflation.

The Monetary Policy Committee was widely expected to hike the base rate following April’s inflation figures. The Consumer Price Index (CPI) rose by an annual 10.1% in March due to a 19.1% jump in the price of food and non-alcoholic beverages.

The BoE has been aggressively hiking interest rates for over a year now as it tries to get inflation back to its target of 2% – a task that has so far been complicated by record food prices and high energy costs.

Its decision followed the US Federal Reserve, which last week raised its key rate by 0.25% to a range of 5% to 5.25%.

The Fed indicated its tightening cycle might be coming to an end, but the same cannot be said for the BoE. Inflation across the pond has fallen to below 5% for the first time since April 2021, but it’s proving far stickier in the UK.

But the UK is experiencing some pressures unique to the country, which are having a big impact on inflation, as Rob Clarry, investment strategist at wealth manager Evelyn Partners notes:

"First, like the rest of Europe, the UK has experienced a major energy price shock since the Russian invasion of Ukraine."

"Second, the UK has experienced far greater labour shortages than the rest of Europe, similar to what we have seen in the US. Many young European workers have left the UK after Brexit and older workers are leaving the labour force due to long-term sickness. This has placed upward pressure on wages and inflation."

Wholesale energy prices are predicted to fall from July, which could help lower the rate of inflation. Additionally, the chancellor said in his Spring Budget he expects inflation will fall to 2.9% by the end of the year, but in the face of the current figures that estimate seems overdone.

"We expect to see UK inflation start to ease as the base effects turn more favourable and the impact of higher rates is felt by the real economy. In its latest forecasts, the BoE now expects inflation to fall to around 8% for Q2 and 5% by Q4. They expect to meet their 2% target by the end of 2024," says Clarry.

We’ll be updating this page throughout the day with all the latest news and comment on the Bank of England’s latest move, so stay tuned.

Why is the Bank of England raising interest rates?

The rate of CPI inflation was expected to fall below 10% in March, but it came in at 10.1%. While this is a decrease from February’s rate of 10.4%, it’s still over five times the BoE’s 2% target.

The largest contributor to the CPI reading for the month was the food and non-alcoholic beverages category, followed by housing and household services such as electricity and gas.

By hiking interest rates the BoE is hoping to encourage consumers to save money instead of spending it, as higher interest rates increase the cost of borrowing while encouraging lenders to improve the rates on their savings products.

"Increasing interest rates is the main tool central banks use to lower inflation, as it leaves consumers with less disposable income to spend on goods and services, which in turn encourages price setters to keep prices low," says Alice Haine, personal finance analyst at Bestinvest.

"So far, this monetary policy tool is not achieving the desired effect fast enough with household budgets still held hostage by stubbornly high prices," adds Haine.

The best savings accounts are offering the most attractive rates in years, but rising rates have also weighed on the economy.

Members of the MPC have indicated they’re split on whether rising rates further is the way to go. Higher rates are weighing on the property market as they are pushing up mortgage rates, which is prompting many to delay their buying plans.

Haine notes "An estimated 700,000 UK households missed or defaulted on a rent or mortgage payment last month, according to Which?, reflecting the strain higher housing costs can have. Those nearing the end of a fixed-rate opportunity have had little opportunity to catch their breath and take stock of the mortgage market before locking in a fresh deal."

"Whatever happens in the short term, the 1.4 million people with cheap fixed rate deals expiring this year are now facing a significantly more expensive mortgage market than the one they left two or five years ago."

By discouraging spending the BoE is also slowing down the economy. And though the OBR no longer expects the UK to enter a recession in 2023, it still expects the economy to shrink by 0.2% this year.

As Oliver Faizallah, head of fixed income research at Charles Stanley, comments, “Going forward, the Bank of England have a very difficult job, navigating high inflation with a fragile economy. The Bank is likely to remain data dependent as they decide whether to pause or keep hiking. Policy makers and market participants will be looking closely for signs that show that the UK economy is finally giving in to the pressure of all the hikes to date, which would give them confidence that inflation will fall back to target sooner rather than later."

That said, there are signs the economy is holding up better than expected in the face of higher interest rates.

“Growth has certainly been subdued, but the consumer is bouncing back with increased confidence and demand for food services, pubs and restaurants, despite the cost-of-living headwinds. While consumption is yet to return to pre-pandemic levels, a strong UK job market should continue to support consumer activity as we move into the summer months,” says James McManus, chief investment officer, at digital wealth manager Nutmeg.

The rate of inflation in the United States slowed to its lowest rate in two years in April, indicating the Federal Reserve’s efforts to lower prices by hiking interest rates might be starting to work.

The Consumer Price Index (CPI), which measures the cost of a basket of goods, rose 0.4% in April and 4.9% over the last 12 months, but this was a deceleration from 5% the month before. The latest CPI read suggests prices are rising at the slowest rate since April 2021.

Analysts widely expected the figure to remain at 5%, so the lower figure will come as a relief to the Federal Reserve. The central bank has been hiking interest rates over the last year in an attempt to curb rising prices.

What is driving inflation in the US?

The cost of housing also. Housing costs - the largest contributor to the headline figure - increased 0.4% following a 0.6% increase in March. Meanwhile, the energy index rose 0.6% in April, mostly due to an increase in the cost of petrol.

But the rate of inflation was driven down by falling airline fares, which dropped 2.6% over the month. Lower prices for new cars also helped pull down the headline number.

The rate of inflation peaked at 9.1% in the US last June, its highest level since 1981. Though it has since fallen steadily, it remains significantly above the Fed’s 2% target.

What does US inflation mean for interest rates?

Last week the Fed raised its key rate by 0.25%, taking it to a range of 5% to 5.25% – its highest level since 2007.

This marked the tenth consecutive increase in over a year, but Federal Reserve chair Jerome Powell indicated the Bank might be getting “closer” to stopping the rate hikes.

“The consensus is that the Fed's latest rate hike was certainly its last for this cycle, and the Fed will cut the rates by 75bp before the year ends,” says Ipek Ozkardeskaya, senior analyst at Swissquote Bank.

But a rate cut can’t be taken for granted just yet as inflation is still twice the Fed target rate.

On the other hand, the turmoil in the US banking sector “is tightening credit conditions and helping the Fed to do its job – restrict credit in a way to slow growth and ease inflation,” says Ozkardeskaya.

But core inflation is proving stickier, having stayed at 5.5% since the end of last year. “As a result, rate cuts towards the end of the year cannot be taken as a given, and much of it will depend on what the Fed does next,” says Richard Carter, head of fixed interest research at Quilter Cheviot.

“It will be hoping that the latest interest rate rise is enough and that this feeds into the economy in the next couple of months… The Fed will be keeping a close eye on events and as has been proven over the course of the last three years, nothing can be taken for granted. In the immediate term, a pause now seems on the cards, but beyond that remains as volatile as ever.”

• The US Federal Reserve is likely to keep rates higher for longer, supporting more defensive positioning
• Income seekers have a wider range of options this year
• It is a better environment for ‘value’ companies, rather than high growth areas such as technology

2022 created a new environment for income investors. After a decade where income was scarce, the US Federal Reserve (‘Fed’) raised interest rates eight times over the year. Financial markets saw a major adjustment. In bond markets, there was a significant rise in yields, in stock markets, high growth areas came under pressure, while ‘value’ areas thrived.

With 2023 well underway, the process of adjustment is largely complete. Investors continue to speculate about a potential Fed pivot that would see it ease its tightening policy, but it is increasingly clear that the past decade has been an anomaly. Interest rates are likely to remain at more normal levels by historic standards.

We believe financial markets are still too optimistic about the prospect of a pivot from the Federal Reserve in the second half of this year. The central bank will almost certainly keep rates at a higher level. It doesn’t want to make another error by cutting too early and keeping inflation around. There are still significant pressures in the labour market and wages are rising. If there is a pivot, it is more likely to be because of significant bad news in the economy so may not be good for markets.

Market impact

This leads us to a defensive tilt in The North American Income Trust portfolio. Rather than taking sector bets, we are looking for the strongest and more defensive options within each sector. Higher interest rates will push investors to look more closely at valuations. When the cost of capital is negative and companies have unlimited ability to tap capital markets, valuations don’t matter as much, but with the Fed Funds rate at 5%, investors care about profitability once again.

We see ongoing support for more ‘value’ areas of the market – well-priced companies with strong balance sheets and cash flow. Given the strength of some growth areas over the past decade, there is still considerable adjustment to be made in spite of the outperformance of value companies last year. Growth companies still appear highly rated, even where their outlook is uncertain. The market does not appear to be factoring in the impact of a potential recession for many of these companies.

Buoyant outlook for income

The outlook for income is buoyant. There is certainly greater competition for capital now with higher quality bonds yielding 5-6%. Dividend portfolios tend to yield 3-3.5%. However, income strategies – including ours – strive to combine growth and income. In the Trust, we have limited exposure to ‘bond proxy’ areas. These are areas such as utilities that pay a reliable dividend year after year, but where that dividend doesn’t grow significantly, giving them bond-like characteristics.

In contrast, many of the companies in our portfolio are growing their pay-outs at 5-10%. We have a progressive dividend policy, so aim to outpace inflation. That has been difficult over the past 12 months but should become easier over time.

Our portfolio holds 35-40 companies, allowing us the space to focus on companies’ balance sheets, cash generation and conversion. Holding a long tail of companies can dilute the process. It is difficult to have real conviction in 70 or 80 ideas. This focus has helped us deliver real income resilience over time. We only had one dividend cut during the pandemic and it was small. The Trust has reserves of over a year’s worth of dividends.

Every year brings a fresh set of risks. Last year, politics became a factor, as markets had to digest the impact of the mid-term elections. This year should bring less political noise, though there may be some volatility surrounding the debt ceiling, where both the Republican and Democrat parties need to sign off on the national debt.

2022 was a year of significant adjustment. While the stock market still has to face down significant challenges, the prospect of a more certain interest rate environment and weaker inflation should be beneficial. In the meantime, it is a better environment for income investors than it has been for many years. Given the outlook for valuation and interest rates, dividends are likely to become a more significant part of investors’ total return.

Important information

Risk factors you should consider prior to investing:

• The value of investments and the income from them can fall and investors may get back less than the amount invested.
• Past performance is not a guide to future results.
• Investment in the Company may not be appropriate for investors who plan to withdraw their money within 5 years.
• The Company may borrow to finance further investment (gearing). The use of gearing is likely to lead to volatility in the Net Asset Value (NAV) meaning that any movement in the value of the company’s assets will result in a magnified movement in the NAV.
• The Company may accumulate investment positions which represent more than normal trading volumes which may make it difficult to realise investments and may lead to volatility in the market price of the Company’s shares.
• The Company may charge expenses to capital which may erode the capital value of the investment.
• Derivatives may be used, subject to restrictions set out for the Company, in order to manage risk and generate income. The market in derivatives can be volatile and there is a higher than average risk of loss.
• Movements in exchange rates will impact on both the level of income received and the capital value of your investment.
• There is no guarantee that the market price of the Company’s shares will fully reflect their underlying Net Asset Value.
• As with all stock exchange investments the value of the Company’s shares purchased will immediately fall by the difference between the buying and selling prices, the bid-offer spread. If trading volumes fall, the bid-offer spread can widen.
• The Company invests in emerging markets which tend to be more volatile than mature markets and the value of your investment could move sharply up or down.
• Certain trusts may seek to invest in higher yielding securities such as bonds, which are subject to credit risk, market price risk and interest rate risk. Unlike income from a single bond, the level of income from an investment trust is not fixed and may fluctuate.
• With funds investing in bonds there is a risk that interest rate fluctuations could affect the capital value of investments. Where long term interest rates rise, the capital value of shares is likely to fall, and vice versa. In addition to the interest rate risk, bond investments are also exposed to credit risk reflecting the ability of the borrower (i.e. bond issuer) to meet its obligations (i.e. pay the interest on a bond and return the capital on the redemption date). The risk of this happening is usually higher with bonds classified as ‘sub-investment grade’. These may produce a higher level of income but at a higher risk than investments in ‘investment grade’ bonds. In turn, this may have an adverse impact on funds that invest in such bonds.
• Yields are estimated figures and may fluctuate, there are no guarantees that future dividends with match or exceed historic dividends and certain investors may be subject to further tax on dividends.

Other important information:

Issued by abrdn Fund Managers Limited, registered in England and Wales (740118) at 280 Bishopsgate, London EC2M 4AG. abrdn Investments Limited, registered in Scotland (No. 108419), 10 Queen’s Terrace, Aberdeen AB10 1XL. Both companies are authorised and regulated by the Financial Conduct Authority in the UK.

Find out more at Northamericanincome.co.uk or by registering for updates. You can also follow us on Twitter and LinkedIn.

Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.

At the start of 2022, many investors were looking forward to a brighter year ahead after the turbulence of the pandemic. Even though the world economy appeared to be on a bumpy path to recovery, the outlook was still better than it had been for two years.

Then Russia’s invasion of Ukraine fundamentally changed the outlook, ushering in one of the toughest years for financial markets on record.

Prices had already been pushed higher by supply chain disruption, a direct result of the pandemic, and the Russian invasion brought a spike in energy prices, contributing to mounting inflationary pressures.

Central banks acted decisively, raising interest rates, and withdrawing quantitative easing measures. In doing so, they reversed the decade-long low-interest rate regime. That regime had helped support both bond and equity markets. Its withdrawal saw considerable disruption across financial markets.

These actions created the perfect storm for investors. Stock market volatility exploded, particularly in the previously-strong technology sector. And bonds, which are traditionally seen as safe havens, failed to provide their usual support. Both equities and bonds sold off significantly in 2022.

Only a narrow range of companies and sectors escaped the carnage and managed to make progress. The energy sector benefited from strong commodity prices and higher profits. This has also helped commodity-dependent countries, such as Latin America.

There have been some anomalies as well, such as India. The region has recovered well from the pandemic and the equity market has outperformed compared to other emerging markets.

But despite these bright spots, it has been a gloomy year for most other asset classes.

The year ahead

There are relatively few signs of the environment improving in the near term. As such, ISA investors may need to accept assets will remain volatile for some time to come.

The Federal Reserve has made it clear that its priority is to tackle inflation, whatever the impact on short-term economic growth. This is echoed by other central banks around the world that recognise the need for price stability.

Nevertheless, financial markets have fallen a long way in 2022 and valuations are much lower than where they started the year.

What’s more, there are plenty of good companies out there with strong growth and income potential.

At BlackRock, we continue to look for those companies that can deliver value in all economic conditions.

Investment discipline

In this type of febrile market, we believe investors need to fall back on sound investment disciplines. Holding a wide range of assets is particularly important at a time when traditional diversification strategies, notably holding bonds and equities, have not worked as well. This means looking beyond traditional markets such as the UK or the US, to those markets that have their own self-sustaining growth stories.

Emerging markets risk: Emerging market investments are usually associated with higher investment risk than developed market investments. Therefore, the value of these investments may be unpredictable and subject to greater variation.

Diversification: Diversification and asset allocation may not fully protect you from market risk.

This applies not just to capital growth, but also to income. In BlackRock’s investment trusts, we use the full powers of the investment trust structure to explore ideas in overlooked areas, which open-ended funds have to ignore due to liquidity constraints. These may be illiquid frontier markets, royalty investments or option writing strategies to boost dividend income. We may also reserve income in buoyant markets to pay out in tougher times.

Strong stock picking is also key as a difficult economic environment exposes weak companies. Those with high debt levels could see their repayments rise, while those without pricing power may not be able to put up their prices to cover higher costs. Strong companies can grow even stronger during a downturn by taking market share from struggling rivals.

At BlackRock, we draw on our global analyst network to pick up the most compelling ideas.

The investment trust structure can be important in allowing us to take full advantage of those opportunities. In difficult markets, liquidity can be a problem. It can be tough to move in and out of positions. Open-ended funds may be forced to sell holdings to meet redemptions. In contrast, closed-ended funds have the flexibility to invest as they see fit.

Good risk analysis is also an important discipline in febrile markets. It is important for a fund manager to understand their exposure to different areas: to a rise or fall in interest rates, for example, or a spike in the oil price. This risk discipline is integral to everything we do at BlackRock. We arm our fund managers with all the risk tools they need to understand the decisions they take on investors’ behalf, such as the Aladdin platform which provides sophisticated risk analytics.

Risk Warning: While proprietary technology platforms may help manage risk, risk cannot be eliminated.

2023 could be another difficult year, making it hard to choose the right investments for an ISA, but there are opportunities in all market conditions. We aim to put ourselves in the strongest possible position to take advantage of those opportunities.

For more information on BlackRock’s range of investment trusts, please visit www.blackrock.com/its

Risk Warnings

Past performance is not a reliable indicator of current or future results and should not be the sole factor of consideration when selecting a product or strategy.

Changes in the rates of exchange between currencies may cause the value of investments to diminish or increase. Fluctuation may be particularly marked in the case of a higher volatility fund and the value of an investment may fall suddenly and substantially. Levels and basis of taxation may change from time to time.

Important Information

Issued by BlackRock Investment Management (UK) Limited, authorised and regulated by the Financial Conduct Authority. Please refer to the Financial Conduct Authority website for a list of authorised activities conducted by BlackRock.

BlackRock has not considered the suitability of this investment against your individual needs and risk tolerance. To ensure you understand whether our product is suitable, please read the fund specific risks in the Key Investor Document (KID) which gives more information about the risk profile of the investment. The KID and other documentation are available on the relevant product pages at www.blackrock.co.uk/its. We recommend you seek independent professional advice prior to investing.

The Company is managed by BlackRock Fund Managers Limited (BFM) as the AIFM. BFM has delegated certain investment management and other ancillary services to BlackRock Investment Management (UK) Limited. The Company’s shares are traded on the London Stock Exchange and dealing may only be through a member of the Exchange. The Company will not invest more than 15% of its gross assets in other listed investment trusts. SEDOL™ is a trademark of the London Stock Exchange plc and is used under licence.

Net Asset Value (NAV) performance is not the same as share price performance, and shareholders may realise returns that are lower or higher than NAV performance.

Any research in this material has been procured and may have been acted on by BlackRock for its own purpose. The results of such research are being made available only incidentally. The views expressed do not constitute investment or any other advice and are subject to change. They do not necessarily reflect the views of any company in the BlackRock Group or any part thereof and no assurances are made as to their accuracy.

This material is for information purposes only and does not constitute an offer or invitation to anyone to invest in any BlackRock funds and has not been prepared in connection with any such offer.

© 2023 BlackRock, Inc. All Rights reserved. BLACKROCK, BLACKROCK SOLUTIONS and iSHARES are trademarks of BlackRock Inc. or its subsidiaries in the United States and elsewhere. All other trademarks are those of their respective owners.

MKTGH0123E/S-2647934

The Bank of England (BoE) has raised its base rate by 0.25% to 4.25%, its highest level since October 2008.

The central bank was widely expected to hike rates today following a surprise jump in inflation to 10.4% as announced by the Office for National Statistics yesterday.

Still, the rate-setting Monetary Policy Committee (MPC) faced a difficult balancing act going into their meeting today.

The collapse of Silicon Valley Bank and Credit Suisse has caused turmoil in the banking sector, leading some analysts to predict the BoE would pause hikes to reassure markets.

But it seems the BoE believes the fight against inflation is more important as it runs over five times ahead of the central bank’s 2% target.

“No one could say the Bank of England’s decision to raise the base rate to 4.25% was unexpected,” says Emma-Lou Montgomery, associate director for personal investing at Fidelity International

“The surprise jump in UK inflation to a 45-year high of 10.4% in February, while an 11th-hour shock, only reinforced expectations that the BoE would have no choice but to raise interest rates again.

“The Bank of England also had no choice but to acknowledge that inflation is firmly in the driving seat, with concerns over the global banking crisis set aside in favour of tackling a troubling spike in the cost of living,” said Montgomery.

The BoE’s hike follows the Federal Reserve, which hiked interest rates by 0.25% yesterday.

We’ll be updating this page throughout the day with all the latest news and comment on the Bank of England’s latest move, so stay tuned.

Why is the Bank of England raising interest rates?

The CPI inflation rate was expected to continue to slow in February, with analysts projecting a figure of 9.9%. However, the rate came in much hotter than expected at 10.4%.

Food inflation is running at 18.2%, its highest-ever level. Rising prices at restaurants and hotels also increased 12.1% year-on-year in February.

The BoE is attempting to get inflation under control by hiking interest rates, and encouraging savers to put money away and not spend it.

But while savings accounts now offer some of the best rates in years, higher borrowing costs are projected to weigh on economic growth.

The 0.25% hike is gentler than the past two 0.50% hikes and the 0.75% increase last November. And “with the decision from the nine-strong Monetary Policy Committee split - with seven favouring a 0.25% increase and two wanting no rate hike at all - it signals some trepidation about pushing ahead with a rate rise amid the uncertainty,” says Alice Haine, personal finance analyst at Bestinvest.

The Office for Budget Responsibility (OBR) expects the UK economy to shrink by 0.2% this year, although it no longer expects the UK to enter a recession in 2023.

Furthermore, the International Monetary Fund expects the UK to be the only G7 economy to shrink in 2023.

The OBR also expects the rate of inflation to fall to 2.9% by the end of the year, but right now the forecast seems optimistic, and the latest data from the ONS shows the path there is far from straightforward.

The bank also acknowledged the economic impact of the failure of SVB and Credit Suisse, adding it would issue a full assessment in its next update in May. Still, it said the UK banking system “maintained robust capital and strong liquidity positions and was well placed to continue supporting the economy”.

Will the Bank of England continue to raise interest rates?

“Whether this is the end of the rate hiking cycle is unclear, but thankfully, the outlook from here is not entirely bleak,” continues Haine.

“The UK narrowly avoided a recession last year and is expected to do the same in 2023. In addition, both the BoE and the Office for Budget Responsibility expect inflation to slide as a result of easing wage growth and falling energy prices.”

Following the chaos caused by the mini-Budget last September, analysts were expecting rates to rise to as much as 6%, but now analysts now estimate rates will peak at 4.5%.

Andrew Bailey, the BoE’s governor, has said that even though inflation had started to fall the Bank couldn’t afford to take its foot off the pedal and risk a return to the levels of inflation seen in the 1970s. Two MPC members voted to maintain the rate at 4%.

Encouragingly, the BoE said it expected inflation to fall sharply over the coming months as energy prices decline, which could signal an end to the rate hikes in the near term.

However, the Bank said “if there were to be evidence of more persistent pressures, then further tightening in monetary policy would be required”, so at this point, it’s still a waiting game.

What do rising interest rates mean for you?

Rising interest rates increase the cost of borrowing, meaning mortgage rates are likely to rise in the coming weeks.

“A rise to base rate will come as disappointing news to borrowers who are not locked into a fixed rate mortgage, as their monthly repayments may rise in the coming months amid a cost of living crisis,” says Rachel Springall, finance expert at Moneyfactscompare.co.uk.

But borrowers looking to refinance “might be pleased to see that fixed-rate mortgages have fallen since the tail end of 2022 and that it is currently cheaper on average to lock into a five-year fixed rate over a two-year fixed deal”, says Springall.

“The incentive to fix is clear from the continued rise to the average Standard Variable Rate (SVR), which is now above 7%, a level not breached since 2008,” Springall adds. “A rate rise of 0.25% on the current average SVR of 7.12% would add approximately £772* onto total repayments over two years.”

However, affordability will remain an issue for first-time buyers. “With this most recent increase in the base interest rate, the cost of borrowing remains much higher than previous years,” says Kellie Steed, mortgage expert at Uswitch. “Buyers who are not yet on the property ladder will need sizable deposits in order to access the most favourable interest rates.”

“It's possible that first-time homebuyers will find it more affordable to purchase a home towards the end of 2023 because both house prices and fixed mortgage rates are anticipated to continue falling throughout the year,” adds Steed.

The property market has been slowing down for months due to rising rates. Most house price indexes show house prices have been falling over the last few months.

The latest data from HMRC showed property transactions are down by nearly 20%, and the OBR expects prices will fall 10% by 2024.

And it's not just mortgages they're becoming more expensive. All rates on types of borrowing, from car finance to credit cards, are likely to rise following the BoE's announcement.

“While unsecured borrowing such as a personal or car loan is not typically impacted by an interest rate rise because the terms of the finance have already been agreed, those with credit card debt or an overdraft could see their rates change if their lender passes on the rise in borrowing costs,” says Haine.

As for savers, even though they have been enjoying better rates on savings accounts, higher interest rates don’t always translate into higher savings rates.

“It could take months for the increase in interest rates to trickle through to savers – if at all,” says Myron Jobson, senior personal finance analyst at interactive investor. “The acceleration in the frequency of rate rises has meant that some savings providers may still be catching up to past base rate rises.”

If inflation does fall to 2.9% as the OBR has predicted, the savings rate increase cycle could be “nearing its end”, says Jobson.

“But there is still plenty of uncertainty, and inflation could remain stubbornly higher for longer,” continues Jobson. “While you might get a better rate in the near future, there are no guarantees – and an uptick in savings rates could mean the difference between pennies and hundreds of pounds depending on how much you have to save.”

Nearly half of US startups had accounts with Silicon Valley Bank (SVB). So it’s no surprise SVB’s collapse late last week has shaken the industry and prompted wider concerns about the state of the banking sector.

SVB was declared insolvent by the Federal Deposit Insurance Corporation (FDIC), the US banking regulator, on Friday after depositors withdrew more than $40 billion of the bank’s approximately $170bn in assets.

The bank’s collapse is the largest of a US lender since the financial crisis in 2008.

SVB UK was also swept up in the collapse. But HSBC announced today it was purchasing the bank, which counts over 3,000 UK clients including tech and science start ups, for £1.

But what happened to SVB, and what does its collapse mean for investors?

What happened to Silicon Valley Bank?

Tech companies boomed throughout the pandemic, which benefitted SVB. It had a lot of money in deposits, which it invested in long-term, fixed-rate US government bonds.

That’s where the problem started.

SVB invested in long-term bonds in the hopes of making more money in a low-interest rate environment. The problem with this strategy is that long-term bonds tend to be more sensitive to interest rates changes.

When interest rates are low, bond prices rise. But when interest rates are high, bond prices fall.

Interest rates remained low throughout the pandemic. But central banks across the world have been hiking them successively over the last few months in order to control inflation.

So when the US Federal Reserve began hiking its base rate, SVB’s bond portfolio plummeted in value.

This spooked depositors who started withdrawing their money. In order to free up capital, SVB dumped its long-term bonds, realising a multi-billion dollar loss.

The lender’s management then tried to raise $2bn to fill the capital gap, but this only caused further panic among the lenders customers.

Customers initiated withdrawals of $42bn in a single day, and the bank was unable to acquire the funds. Shortly after it was declared insolvent by the FDIC.

This was the biggest bank collapse in the US since the financial crisis in 2008.

But Treasury Secretary Janet Yellen said the federal government would not bailout SVB like it did for other banks in 2008.

However there are reports the FDIC is leading an auction to find a buyer for SVB.

The US government said that it will be guaranteeing deposits for SVB account holders, who would be able to access their money from March 13.

The FDIC typically guarantees deposits of up to $250,000, but the government has said it will pay out for all deposits.

What happened to SVB UK?

The future of SVB UK was uncertain following the collapse of its parent company, causing concern among the 3,300 companies that bank with it.

The Bank of England was planning to put SVB UK into insolvency, but HSBC stepped in to purchase SVB UK for £1.

This should “end the nightmare thousands of tech firms had been experiencing over the past few days,” says Susannah Streeter, head of money and markets at Hargreaves Lansdown.

“HSBC shareholders may have some concerns about the bank snapping up assets which have been under such a cloud of uncertainty, particularly the exposure to bonds, but HSBC says it expects a gain to arise from the acquisition.

“This will be hugely welcomed by the government, given the looming crisis risked overshadowing Budget Day, as a big tech sector bailout would not have been a good look when millions have been told there is little extra money to ease the cost-of-living crisis,” Streeter said.

What does this mean for investors?

Understandably the news has spooked investors, and raised questions about whether we’re headed for another financial crisis.

US president Joe Biden and Treasury Secretary Janet Yellen have both attempted to calm markets.

As well as guaranteeing investors’ deposits, the FDIC is offering loan facilities to other banks who hold bonds that have plummeted in value.

Crucially under the loans the assets will be valued at the price they were issued, not their current market price, which will help prevent losses.

The money will come from fees banks pay into the deposit insurance fund, not from taxpayers as it did in the financial crisis.

But still fears remain that smaller US banks “could become the latest dominos to fall”, added Streeter.

Some of the US’s biggest banks have seen their share prices fall following SVB’s collapse. Wells Fargo, Citigroup and Bank of America are down 7.5%, 6% and 7% respectively.

Shares in banks listed on the FTSE 100 also fell – Standard Chartered dropped by 7%, Barclays by 5.5% and HSBC by 4.5% as investors worry about the implications of the purchase of SVB UK.

But the purchase means UK startups will have access to their funds, so they should be able to continue running business as usual.

“The speed of the response by the Treasury shows the importance it places on the UK technology and healthcare sectors and their contribution to the economy,” said John Glencross, CEO and co-founder of VCT manager Calculus. “The UK venture capital, start up and scaleup community should feel reassured by the outcome.”

“The current turbulence may be unsettling, but long-term investing takes endurance and patience and rather than switching and ditching stocks, riding out the storm is almost always a good strategy when things look rocky,” says Streeter.

“This is the time when the priority should be ensuring investors have a diversified portfolio with a wide range of holdings across different asset classes, sectors and geographies.’’

We’ve picked out three stocks to buy that should perform well in a high interest rate environment as inflation remains stubbornly high.

Indeed, even though central banks around the world have raised interest rates to highs not seen since the 2008 financial crisis in response to double-digit inflation, it does not look as if inflation is going to fall any time soon, suggesting rates could remain high for some time.

In the UK the Monetary Policy Committee raised rates to 4%. In the US the Federal Reserve raised rates to between 4.5 to 4.75%, and the European Central Bank’s base rate sits at 2.5%.

A high interest rate environment spells bad news for investors. In theory high interest rates discourage spending and encourage saving. Reduced consumer demand doesn’t bode well for companies.

High interest rates also push up the cost of borrowing, meaning companies with lots of debt are likely to struggle. That said, there’s a few sectors that are more sheltered from broader conditions, and might even benefit from them.

Here are our three favourite stocks to buy in the current interest rate environment.

3 stocks to buy in a high interest rate environment

NatWest (LSE: NWG)

Banks benefit from rising interest rates because their net interest margin expands. This means they make a profit from charging a higher rate on products such as loans and mortgages, than they pay on deposits, like savings accounts.

The bank’s net interest margin, the difference between what it pays out and what it receives in interest payments, widened to 2.85% in 2022 from 2.30% in 2021. The wider the gap, the higher the bank’s profits.

NatWest predicts interest rates will hold at 4% throughout 2023. The bank recorded profits of £5.1bn before tax in its 2022 full year results, up from £3.8bn a year earlier.

Additionally the bank announced a £800m share buyback programme, as well as a dividend of 10p per share as a reward to shareholders.

But despite the positive results, NatWest’s share price dropped by about 9% after the figures were released. This is largely due to the bank’s subdued outlook for 2023, combined with uncertainty around the UK economy for the year.

Higher interest rates also mean more people are likely to default on their loans. The bank has set aside £337m to prepare itself for defaults.

Still, the lender thinks its customers “are so far resilient”, with bad debt losses coming in at 0.09% of the loan book, “and much of that was assumptions about what’s coming next, rather than loans that have already soured”.

The bank has come a long way since it was bailed out by the government in the wake of the financial crisis. Today it looks well poised to navigate future turmoil, and will continue to benefit from the high interest rates environment.

Diageo (LSE: DGE)

Odds are, if you drink alcohol, you’ve probably tried at least one of Diageo’s products. The spirit maker owns over 200 well-known, well-loved brands, including Guinness, Baileys and Captain Morgan rum.

Consumers turn to these brands because they’re well-known, and they might prefer them to a supermarket’s own brand, for instance. This gives the company pricing power, enabling it to pass costs onto consumers.

That’s evidenced in Diageo’s interim results, released in January. Despite price increases to its beers, net sales were up 18% showing consumers are willing to pay a higher price for their drinks.

Additionally a lot of its brands are considered premium, consumed by drinkers with more discretionary income. As such, demand is less likely to be affected by inflation and the cost of living.

In its interim results announced in December, Diageo announced it had commenced a share buyback programme due to return £500m to investors as well as a 5% increase to its dividend, which has grown consistently over the last few years.

The company has also caught on to the fact younger people are drinking less, so it’s investing in non-alcoholic drinks to expand its portfolio.

Diageo has a simple business model and solid products, which should support the business through these tough times.

AstraZeneca (LSE: AZN)

The need for healthcare is going to exist no matter the economic climate, so despite peaks and troughs, pharmaceutical companies will likely always have a level of demand for their products.

AstraZeneca is perhaps most known for its Covid-19 vaccine. But the company has a wide range of treatments, and a lot of projects in its pipeline.

Additionally, due to patents, it has a certain level of protection over its products. While other companies might be making similar drugs, these patents and strong relationships with health providers gives it a certain level of pricing power.

The vaccine boosted its share price throughout the pandemic, but it’s likely got further to go. Demand for its cancer treatment, which is a big and growing part of its portfolio, is strong and, unfortunately, unlikely to diminish.

Moreover, the world’s population is ageing, which means more people will require medical treatment.

It looks expensive, but shares could continue to grow as more of its drugs are released and approved. These processes take time, and patents expire, but long term investors will continue to benefit, regardless of what central banks are doing.

More on share tips:

• Share tips of the week – 24 February
• Are housebuilder stocks looking cheap for dividend yields?
• Law Debenture Investment Trust offers something for all investors

• After a tough year, 2023 starts on a more optimistic note for many Asian markets
• China’s reopening may fuel regional growth, while the interest rate cycle may support stock markets
• There will still be fragility in the year ahead and a focus on quality companies with resilient earnings will be crucial

2022 was a challenging year for global markets – and Asia was no exception. While a handful of markets bucked the trend, the weakness of China was a major headwind for the region as a whole. However, at the start of 2023, there are promising signs of change: China is reopening, the interest rate cycle may be turning and companies are showing significant resilience.

Asia has had face down global and domestic problems over the past 12 months. In particular, Covid lockdowns, political tensions and problems in its property sector have seen China act as a drag on regional growth. Countries with commodities exposure, such as Australia and Indonesia have been rare exceptions to the general weakness, with India also a surprise source of resilience during a tough year.

2023 begins more optimistically. Whilst it’s certainly true that a recession in the West may dent demand for Asian exports and weigh on growth, there are nonetheless noteworthy signs of a shift in the economic cycle within Asia. Most important is the potential for a shift in the monetary policy cycle across the region. Asian central banks have followed the lead of the US Federal Reserve, but inflationary pressures have not been as acute, and rate expectations are now peaking. This should support Asian economies in the year ahead.

Unlike many Western economies, there is still structural growth in Asia. Many mature economies have a growth problem that is likely to continue even as the interest rate cycle turns. Debt burdens built up during the pandemic may constrain economic activity in the near-term. In contrast, the long-term growth drivers for Asia are still intact – a growing middle class, rising consumer spending, low debt and innovation.

Finding the right opportunities

This stronger economic growth backdrop should support the Asian corporate sector. Companies across the region are undoubtedly seeing rising input costs and margins coming under pressure, though this eased in the final quarter of 2022. abrdn New Dawn Investment Trust has been focused on finding those companies with strong and leading market positions, giving them power in pricing and procurement. This has helped protect the trust against earnings downgrades. These have stepped up as economic growth has weakened

Markets have re-priced over the year, with valuations far lower than at the start of 2022. Valuations are now at a level likely to appeal to trade buyers and this may be a catalyst for merger and acquisition activity. Companies have sufficient cash to fund acquisitions if they find the right opportunities. India is the notable exception, where valuations are high after a resilient year for the country’s stock markets.

The China situation

China’s revival will be important in the year ahead. abrdn New Dawn has been underweight China but has made selective investments there more recently and is overweight Hong Kong. There has been a high profile shift in the government’s handling of Covid, with the country opening up travel and reducing quarantine requirements. There has also been some improvement in the country’s fragile property sector.

China is still home to a range of innovative companies and is an important driver for economic growth in the wider region. We have reinvested in online food delivery business, Meituan Dianping, which has resolved its regulatory concerns. We also hold AIA Group in Hong Kong, which should be a beneficiary of China’s reopening, while also benefiting from the interest rate cycle.

The wider portfolio

The financial sector should be a key beneficiary of the reopening in China and elsewhere, with demand for credit growth increasing and higher interest rates allowing for improved margins. The trust holds a number of banks in India, playing on the domestic growth theme, but also in smaller Asian markets where financial inclusion is increasing.

The abrdn Indian Equity Fund remains the largest single holding in abrdn New Dawn. India is dependent on imported oil, and oil prices have dipped in recent months, inflation remains benign and Indian companies continue to deliver strong earnings. The economy is also supported by a cyclical recovery in infrastructure, increased government spending and credit growth.

Regional giants, such as TSMC and Samsung had a tough year in 2022, but a recovery in the memory sector is likely in the year ahead as supply chains unlock and demand revives. Valuations also look more attractive. The trust retains exposure to the sector, albeit at a lower level than at the start of 2022.

2022 was a tough year. 2023 should be a better year, but with global recession risk looming, it won’t be plain sailing. However, Asia is in a better place to the rest of the world and a focus on quality companies should bring resilience.

Companies selected for illustrative purposes only to demonstrate the investment management style described herein and not as an investment recommendation or indication of future performance.

Important information

Risk factors you should consider prior to investing:

• The value of investments, and the income from them, can go down as well as up and investors may get back less than the amount invested.
• Past performance is not a guide to future results.
• Investment in the Company may not be appropriate for investors who plan to withdraw their money within 5 years.
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US inflation seems to be accelerating again. According to the latest numbers, published today, CPI inflation across the country hit 6.4% in January, compared to the previous reading of 6.5% in December. Analysts and economists were projecting a rate of 6.2%.

What’s more, core inflation, the measure of inflation that strips out the volatile food and energy components, came in at 5.6% compared to expectations of 5.5%. The reading was 5.7% in December.

This figure suggests that inflation is becoming more embedded in the economy, and consumers, as well as businesses, are pushing up their prices to compensate for persistently higher costs.

What the latest US inflation data means for the economy

The January inflation report was highly anticipated by the market. The US Federal Reserve has been hiking interest rates to try and bring inflation under control recently. This has sparked concern that the central bank could cause the economy to grind to a halt, as it fights to get prices lower.

“We see ourselves as having a lot of work left to do,” Fed Chair Jerome Powell said earlier this month, suggesting the central bank is going to push interest rates higher throughout the rest of the year.

While this inflation report was worse (inflation was higher) than expected, it wasn’t terrible. After all, CPI inflation is still heading in the right direction, it's just not falling as fast as some analysts and economists might have expected.

As Chris Beauchamp, chief market analyst at IG Group says, “US inflation is still resolutely sticky, and it shows the Fed still has more to do. But the numbers were broadly in line with what markets had been expecting, and were certainly not enough to frighten the horses too much.”

This is good news for investors, but there could be further disruption to come. Even though inflation is starting to moderate, with food and energy prices coming off their one-year highs, it will take some time for higher interest rates to filter through to the underlying economy.

If economic growth begins to slow dramatically, then this could spook markets. On the other hand, if the economy remains stronger than expected, it could lead the Fed to push rates even higher, and that could hurt asset prices.

“The muted reaction should not be dismissed – inflation still has the power to scare, but this was not the reading to do it. If we get another barnstormer of a jobs number then markets will go back to fretting about more sustained inflation, but for now calm reigns,” notes Beauchamp.

The Bank of England (BoE) has raised its base rate by 0.5% to 4% – the highest level since 2008.

The rate hike - the 10th consecutive increase - was widely expected as the BoE continues to wrestle with double-digit inflation.

James McManus, chief investment officer at Nutmeg, comments, "“This is the tenth consecutive increase in the Bank of England’s base rate, which shows how determined policymakers have been to ‘normalise’ monetary policy. The base rate was cut to a historic low of 0.1% in March 2020 as the Covid pandemic wreaked havoc on the economy, and since then the only way has been up. That’s not necessarily a bad thing for the economy, as keeping interest rates close to zero can have unintended consequences in areas from inflation to house prices and debt levels."

The rate of CPI inflation slowed for the second month in a row to 10.5% in December but remains miles away from the BoE’s 2% target.

Rising food prices and higher energy costs are the primary drivers behind inflation, even though the government has tried to curtail energy costs with the Energy Price Guarantee.

The BoE has admitted rate rises could help push the economy into a recession, but it can’t afford to slow down just yet with inflation remaining in the double digits.

However, on the other side of the pond, the US Federal Reserve has slowed its pace of rate hikes.

Yesterday the central bank increased its base rate by a quarter of a percentage point after a 0.5% increase in December following the latest inflation data from the US, which showed a slowdown in inflation.

We’ll be updating this page throughout the day with all the latest news and comment on the Bank of England’s latest move, so stay tuned.

Why is the Bank of England increasing interest rates?

Even though the rate of CPI inflation slowed to 10.5% in December from a peak of 11.1% in November, it’s still far too high.

In theory, by increasing the cost of money consumers will be encouraged to save, and less inclined to spend – indeed, customers are already benefiting from some of the best rates on savings accounts in years.

If people reduce their spending, businesses are left to compete for the remaining customers, usually by reducing prices.

But this doesn’t always work out in practice, especially when inflation is being driven by factors the BoE cannot control, such as rising energy and food prices due to Russia’s invasion of Ukraine last year.

Analytics group Kantar showed grocery price inflation hit a record 16.7% in the four weeks to January 2023.

Energy prices look unlikely to come down in 2023, and now the RAC has warned petrol prices look likely to rise.

It looks as if these inflationary pressures will be with us for some time.

How much further will interest rates rise?

While it looks as if inflation has peaked, as noted above, there are still plenty of reasons to believe prices will continue rising.

That makes it much harder to say for sure when the BoE will stop hiking.

As the Fed noted yesterday when it published its interest rate decision, “ongoing increases” might be needed to continue lowering the rate of inflation.

As such, it looks as if both central banks might continue to increase rates further in the months to come.

Still, it seems unlikely rates will hit the levels predicted last year.

Following the chaos brought on by the mini-Budget, markets were predicting rates could peak at 6%.

However, they are now forecast to rise to 4.5% and remain there throughout 2023, although these are just projections.

The BoE knows further rate rises will continue to slow the economy – GDP shrank by 0.3% in the three months to November 2022. The IMF has said it expects the UK to be the only G7 economy to contract this year after it revised updates. The MPC is likely to take all of this into account going forward.

The good news is that the BoE's new economic forecasts are far more optimistic than they were.��

As David Goebel, Investment Strategist at wealth manager Evelyn Partners says, "Better than expected data in terms of GDP (0.1% for November, relative to expectations of -0.2%), and strong wage growth led the Bank to improve its growth expectations for 2023 to -0.5% from their previous estimate of -1.5% in November. This upgrade has led to a significant reduction in the forecast depth and length of recession facing the UK, with the economy now set to contract by almost 1% over five quarters, rather than 2.9% over eight quarters."

What do rising interest rates mean for you?

Higher interest rates increase the cost of borrowing. The impact they have had on the property market is clear – mortgage borrowing fell by £1bn in December as buyers retreated from the market due to higher mortgage rates.

Nationwide reported UK house prices fell for the fifth consecutive month in January, as growth slowed to 1.1% from 2.8% in December.

Simon Gammon, Managing Partner at Knight Frank Finance, notes, "Fixed rate mortgages are now as cheap as they are going to be for some time, or at the very least are close to bottoming out.

"Before Thursday's decision, the best five year fixed products could be found as low as 4.19%, while the best trackers sat at around 3.94%," Gammon adds. That's compared to around 2% a year ago.

Knight Frank believes house prices could fall by as much as 10% as buyers and sellers get used to the "new normal" for mortgage rates.

It's not just mortgages that are getting more expensive. All forms of borrowing are becoming more costly, from credit cards to personal loans and business loans. Every business and consumer that uses borrowing to support themselves is going to have to deal with higher credit costs.

And savers have enjoyed some of the best rates they have seen in years - the best regular savings accounts are offering rates of up to 7% - real interest rates (after inflation) are still negative, meaning savers' purchasing power is declining.

This combination of inflation, low real interest rates and high borrowing costs is a toxic combination for businesses and consumers.

George Lagarias, Chief Economist at Mazars comments, “Persistent inflation and higher rates which have begun to translate into much higher mortgage payments will continue to eat into real disposable incomes in the coming months."

"We believe that until inflation is materially down, the next few months could be some of the most difficult for consumers in recent years," Lagarias adds.

It's going to continue to be tough for investors and savers as well. To prevent inflation from eroding their purchasing power, savers need to shop around for the best deals, while investors need to carefully review their current holdings.

As Les Cameron, savings expert at M&G Wealth notes, "“As savings rates begin to creep up, people should shop around to secure competitive rates for their cash savings. The fundamental issue remains though, interest rates are substantially lower than inflation so getting a better rate for your cash or a better than cash return on investments will help stem the erosion of value of your money, and will help to ensure your finances are more resilient against future challenges.”

The US Federal Reserve raised interest rates by 0.5%, taking the base rate to a 15-year high as part of its attempts to control rising inflation.

The benchmark interest rate now sits at a range of between 4.25% to 4.5%.

However, it looks as if the central bank is going to slow the pace of rate hikes going forward.

After announcing the rate change, Jerome Powell, chair of the Federal Reserve, said “the appropriate thing to do now is to move to a slower pace” and see how the economy responds to higher interest rates.

He also said the Fed expects inflation to remain high into next year. The US Bureau of Labor Statistics reported earlier this year that prices have risen by 7.1% from last November, increasing 0.1% from October.

The Fed’s interest rate announcement preceded the BoE’s interest rate hike of 0.5% as both central banks face the difficult task of controlling rising inflation without causing too much harm to their respective economies.

Why is the Federal Reserve raising interest rates?

While November’s 7.1% figure is an improvement from June’s 9.1% rate of inflation, which was the highest in 40 years, it’s still three times higher than the Fed’s target of 2%.

The Federal Reserve has been increasing rates at a fast pace as it looks to control inflation.

The easing figures in October were mostly due to falling gas prices. However, the cost of healthcare, rent, and dining out remains high with rent driving the cost of living up the most.

Increased interest rates make the cost of borrowing higher, which in turn encourages saving.

So in theory, they should help bring prices down as people spend less and businesses compete for custom by decreasing prices. But because they discourage spending, they also slow down the economy.

“Inflation has been falling since the summer when the rate peaked at the highest level in over 40 years, 9.1%, compared to yesterday’s 7.1% reading,” says Dan Boardman-Weston, CEO and chief investment officer at BRI Wealth Management.

“This seems to have given the Fed confidence to slow the pace of interest rate increases, even though rates are likely to rise to a higher level and remain there for longer than expected a few months ago.”

But Powell added that while the October and November figures were encouraging, “it will take substantially more evidence to give confidence inflation is on a sustained downward path”.

What do rising interest rates mean for you?

By hiking interest rates the Fed is making it more expensive to borrow money, which should reduce demand for goods and services.

For example, 30-year mortgage rates have spiked to 6.3% over the past year, pushing up the cost of buying a home. As a result, property prices have started to fall as buyers reconsider their options.

Still, with the Fed now expected to slow the pace of rate hikes going forward, borrowers could see rates fall as the market settles into the new normal. Indeed, the average 30-year mortgage rate hit a 20-year high of 7.08% in November, but, as noted above, the rate has now dropped back to 6.3%.

Unfortunately, it does not look as if the central bank will be cutting rates any time soon, suggesting the outlook for equities is going to remain uncertain.

Both the S&P 500 and the Nasdaq saw losses following the Fed’s decision, closing 0.60% and 0.80% lower respectively.

“We expect that higher rates will subdue economic activity in 2023 and that this will lead to corporate profits falling and equities remaining under some pressure,” says Boardman-Weston.

“It’s become clear this year that the Fed is intent on crushing inflation and future expectations of inflation. The higher interest rate environment required to tame inflation comes at the cost of economic growth, which likely comes at the cost of lower stock markets.”

The Bank of England has raised interest rates by 0.5%, which means the central bank’s base rate now stands at 3.5%, the highest level since October 2008.

This is the ninth consecutive increase in the base rate. Last month the bank’s Monetary Policy Committee (MPC), which sets interest rates, decided to raise rates by 0.75%, one of the steepest hikes of the last few decades as inflation surged.

The central bank has been hiking rates to try and control inflation, but policymakers are now worried that hiking rates too far too fast will hurt the economy and they’re starting to take their foot off the pedal.

A month ago analysts were expecting the MPC to hike rates by 0.75% at its December meeting. The slower pace of growth comes as UK GDP shrank by 0.3% in the three months to October and the chancellor warned we are in a recession.

Other central banks are also scaling back their fight against rising prices.

Yesterday the US Federal Reserve announced a rate hike of 0.5%, taking the base rate in the US to 4.5% its highest in 15 years. However, it also said it would be slowing down on its rate increases to see how the economy was responding.

And the European Central Bank has also slowed the pace of hiking. After the BoE announcement, it raised interest rates by 0.5% after a 0.75% jump at its last meeting.

All three banks remain committed to taming inflation while trying to minimise the collateral damage to their economies.

Why did the Bank of England increase interest rates?

While the headline inflation figure fell to 10.7% from 11.1% in November, UK inflation is still running at over five times the BoE’s 2% target.

Higher interest rates increase the cost of borrowing, In theory, this should put people off spending and encourage them to save decreasing demand. Businesses then have to compete for the remaining business usually by cutting prices.

That said, the BoE has admitted its aggressive stance against inflation might be hurting the economy by increasing costs for borrowers and reducing spending.

Additionally, inflation is being driven by factors outside of the BoE’s control.

Food and energy prices have shot up this year largely due to Russia’s invasion of Ukraine, which the central bank cannot control.

How much further will interest rates rise?

This month’s inflation figures would suggest inflation has peaked, and that could mean interest rates won’t rise much higher.

It certainly seems as if that’s the case in the US. After announcing a 0.5% rate hike yesterday, Jerome Powell, the Fed’s chairman, said that though there was still “some way to go” to control inflation, the bank wanted to slow down the pace of rate hikes to see how the economy was responding.

Back in the UK, a couple of months ago analysts were forecasting peak interest rates of nearly 6%, but now it seems they don’t expect the BoE to go much further than 4.25%.

“With fractionally moderating inflation, the looming threat of recession and a slight tick up this week in the unemployment rate, the Bank of England rightfully voted for a more cautious approach to tightening," noted Victoria Scholar, head of investment at interactive investor.

“The Bank of England can feel justified by its counterparts stateside that it made the right decision. Both the BoE and the Fed adopted the same approach, voting for a more dovish 50 basis point hike, having both raised rates by 75 basis points at their previous meetings," Scholar went on to add.

The minutes of the MPC meeting, released after the rate decision, showed that the bank's outlook for the economy is starting to pick up, albeit modestly.

"There was much to like within the minutes," noted Nicholas Hyett, an Investment Analyst at Wealth Club.

"The rising value of sterling is good for our buying power as a nation – taking some of the edge off international inflation. This, together with historic price rises rolling out of the data, mean headline inflation will fall substantially next year," Hyett added.

"That should help ease demands for wage increases, reducing the chances current inflation becomes endemic. Further good news came in the form of easing global supply pressures."

What do rising interest rates mean for you?

Rising interest rates mean higher borrowing costs. This is the case for all debt – loans, credit cards, and mortgages.

Mortgage rates have fallen from their peak of 6.65% in October, but they remain high compared to recent standards. According to Moneyfacts the best two-year fixed-rate mortgage now costs 4.7% compared to 2% this time last year.

Rising rates are particularly bad news for those whose fixed rates end in 2023 – UK Finance estimates this is the case for around 1.8 million homeowners.

As Alice Guy, Personal Finance Editor at interactive investor explained, "rates rises mean someone with a £200,000 tracker mortgage could be paying an extra £326 per month which is an eye-watering annual increase of £3,912."

The effect of rising rates, coupled with the rising cost of living, has already begun to affect the property market and prices are creeping down after two years of fast growth.

Rising rates are also good news for savers. Providers are not obligated to raise rates in line with inflation, and currently, there are no deals out there that come close to helping savers earn a real return on their money.

Still, higher interest rates have been trickling down to the best regular savings accounts, so it could be a good time to look for a better home for your savings.

“Higher interest rates do not always translate to higher savings rates. It could take months for the increase in interest rates to trickle through to savers – if at all. The acceleration in the frequency of rate rises has meant that some savings providers may still be catching up to past base rate rises. Put simply, you may get a better savings rate in the near future – but there are no guarantees. The amount you are looking to save could guide your decision. An uptick in savings rates could mean the difference between pennies and hundreds of pounds depending on how much you have to save," noted Myron Jobson, Senior Personal Finance analyst at interactive investor.

They have also had a positive impact on annuity rates. Rates have hit a 14-year high, breathing life back into a product that for years has been overlooked.

US inflation slowed in October.

The consumer price index rose 7.7% year on year in October, the smallest annual increase since the start of the year.

The figure is below the 8% forecast by economists and down from 8.2% last month.

This reading suggests inflation might have peaked, taking pressure off the Federal Reserve, America’s central bank, which has been trying to combat rising prices by hiking interest rates.

Currently, interest rates in the US sit at 4% after a 0.75% hike last week, their highest level since early 2008.

While Federal Reserve chair Jerome Powell has warned that rates will need to rise further to curtail inflation, the slowdown has ignited speculation the Fed will slow the pace of increases in the coming months.

Why did US inflation decrease?

A lower than expected rise in rent and housing costs was the main reason for the slowdown in US inflation last month.

That said, the property market in the US remains hot, so it could take some time before prices come down sustainably.

Car prices, costs for clothes, medical care and airline fares all declined. The price of food has also stopped rising as quickly as it was before and energy prices in the US have been lower than in Europe, as it’s far less reliant on foreign gas and oil.

However petrol prices did increase slightly, and restaurant prices and hotel rates also remain high.

UK inflation figures are due out 16 November, however the latest data from the Office for National Statistics showed today the economy shrank 0.2% as we head towards a recession.

How did the markets react?

Investors welcomed the figures, with share prices rising in the US, Europe and Asia.

The S&P 500 index rose 5.5% after the data was published, and the Nasdaq Composite index closed 7.4% higher.

Hong Kong’s Hang Seng index rose 5.5%, China’s CSI 300 index gained 1.9% and Tokyo’s Topix index 1.8%.

In Europe the Stoxx 600 gained 2.7%, while the FTSE 100 and the FTSE 250 gained 1% and 3.9% respectively.

The dollar fell 2.3%, while sterling jumped over three cents to $1.17.

The US Federal Reserve hiked interest rates by 0.75% for the fourth time in a row on Wednesday as the central bank continues its fight against inflation.

Following the hike, the federal funds rate, which sets the borrowing benchmark for everything from credit cards to trillions of dollars of financial derivatives that underpin the global financial system, stands at 3.75% to 4%.

However, it looks as if the central bank is going to adopt a more cautious approach when it comes to rate hikes going forward.

The Federal Reserve warns rate rises may slow

According to the central bank’s commentary published alongside the rate decision, it will now be taking into account how far rates have already risen this year, as well as taking into account the time it’ll take for increases to filter through into the real economy when setting rates in future.

Wall Street initially interpreted this statement as meaning that the bank will ease off on increasing rates going forward, but that view was soon squashed.

In a press conference after the rate change was announced, Federal Reserve chairman Jay Powell warned that the so-called “terminal” interest rate (the rate the Fed believes will be needed to tame inflation) will be higher than expected.

In other words, it looks as if the bank is prepared to push rates a lot higher to tame inflation.

Bringing inflation back down to target

The US central bank is aiming to get inflation down to its target of 2%.

By hiking interest rates, the theory is that consumers will look to save more money and businesses will slow spending. This should drive companies to lower prices as they fight over customers’ reduced spending power.

As of yet, it does not look as if higher rates are having the desired effect.

The US inflation rate hit 8.2% in the 12 months to the end of September, higher than forecast, although it was lower than the 8.3% recorded in August.

More importantly the measure of inflation that strips out the volatile food and energy components jumped to 6.6%, the fastest rate since 1982.

It’s this rate that’s worrying the Fed and economists. It means housing and medical costs are still rising and inflation is becoming entrenched in the economy.

That’ll make it harder to control as workers demand higher wages to compensate for increased costs.

What does the Federal Reserve’s war against inflation mean for you?

As the Fed hikes rates further, the cost of credit is rising. The most obvious market where this is having an impact is the mortgage market. The 30-year mortgage rate reached 7.08% last week. That’s the highest level since 2002.

The impact this will have on house buyers’ purchasing power, and as a result, the housing market, cannot be understated.

In December last year, when an average 30-year mortgage cost 3.11% the monthly repayments on a $300,000 would have been around $1,283. Today, the cost to buyers is $2,012 a month.

This suggests either house prices are going to fall, or those with mortgages are going to have to cut back on spending in other areas.

Elsewhere consumers are going to face higher borrowing costs and higher costs in general as companies will likely pass their higher interest costs onto consumers. These price hikes could only add fuel to the inflation fire.

On the other hand, as rates move higher the value of the dollar is surging. This will reduce the cost of imported goods and services and make it cheaper for American consumers travelling overseas.

Remember to get your tickets for the MoneyWeek Wealth Summit hosted by Merryn Somerset Webb, on 25 November 2022! – we’ve got some brilliant speakers lined up and, given everything that’s going on, we’ll have an awful lot to talk about.

Book your place now at moneyweekwealthsummit.co.uk

Inflation in the US remains stubbornly high, the latest figures reveal. The Consumer Price Index (CPI) rose by 0.4% in September following a 0.1% rise in August, translating into an 8.2% increase in inflation over the last 12 months.

The CPI measures the change in prices paid by consumers for goods and services.

Inflation was down from 8.3% in August but remains higher than expected despite the Federal Reserve’s efforts to manage rising prices through interest rate rises. It’s the third month in a row that inflation has fallen, however a Reuters poll of economists had forecast it would drop to 8.1%.

The maintained increase in inflation means the Fed is likely to continue raising interest rates as it attempts to get inflation back to its 2% target. The latest increase came in September, when it set rates to between 3% and 3.25% — the third consecutive increase of 0.75%.

US inflation driven by cost of food, shelter and medical care

Prices were mostly pushed up by increases in the cost of food, shelter and medical care. However, these were partly offset by a 4.9% decrease in the gasoline index. The energy index also fell 2.1%.

The food index rose 0.8% over the month, while the food at home index rose 0.7%. Prices were mostly driven by increases in the cost of fruit and vegetables, cereals and bakery products and the higher price of meats, poultry, fish and eggs.

The Federal Reserve, the US central bank, has already raised interest rates five times since March and analysts expect it to lift rates to between 4.75% and 5% by early next year.

States begin to issue stimulus cheques to help combat inflation

The Federal Reserve sent out stimulus cheques to all Americans throughout the pandemic to help with financial pressures, and now individual states are following suit as inflation erodes residents’ money.

California, Massachusetts and South Carolina are among those sending financial aid to their residents. In California, some residents will be eligible for stimulus cheque payments of up to $1,050.

In the rush to publish and pontificate, media analyses of Budgets are, inevitably, simplistic, shallow and populist. They are often governed by consensus group-think and politically influenced. The interviews with “ordinary people” are designed to support the narrative. Some economists may try to counter misconceptions, but their points are usually ignored and forgotten.

Commentary on last week’s “mini-Budget” contained more misconceptions than most, which may be a positive sign. One former chancellor observed that Budgets which look good on Budget day quickly unravel, while those that attract the most opprobrium stand the test of time.

Criticism from the standpoint of fiscal rectitude focuses on the strategy of borrowing for the purpose of cutting taxes when government debt is so high. In truth, however, debt isn’t especially high: 45% of the national debt – which is now nominally 88% of GDP – has been bought back by the Bank of England, net of which the national debt is below 50% of GDP.

Unless banks go on a pre-2008 style lending spree, and are allowed to do so by the regulators, the Bank will not need to resell that debt and it will be redeemed over time.

Won’t the tax cuts stimulate consumer demand and increase inflationary pressures? Not if the Bank of England responds by stepping up interest-rate increases and so encourages saving. That is an obvious but unspoken objective of the Budget – to achieve tighter monetary policy at the same time as looser fiscal policy.

Bond yields are rising all over the world

The view that the reaction of sterling and the gilt market reflects badly on the Budget in the eyes of financial markets is highly questionable. Bond yields are rising around the world and the UK has had some catching up to do.

Investors believe that while the US Federal Reserve, led by Jerome Powell, takes inflation seriously and is therefore hiking rates aggressively, the Bank of England doesn’t and is not going far or fast enough.

As a result, the dollar is strengthening and partly in consequence, sterling is weakening. A reluctance to tackle inflation is viewed negatively by investors in gilts, so yields have risen, discounting higher inflation in the long term. The Bank of England is probably the cause of sterling and gilt weakness, not the Budget.

Commentators also need to face an electoral reality. John Major’s government in the 1990s focused on getting the public finances back into a strong position. It got no thanks from the electorate and was crushed in the 1997 election.

It handed the Blair government a growing economy and rapidly improving fiscal position, enabling an acceleration in public spending that helped Blair get re-elected twice. Conservatives will not make that mistake again, even if it is the responsible thing to do.

Criticism of the Budget’s measures is also off the mark. Of course tax cuts favour the well-off most: those who pay the most tax will see the biggest monetary (but not necessarily relative) gain. The purpose of cutting the top rate from 45% to 40% is not to favour those who are already well paid, but to raise revenue.

Attracting high earners

The expectation is that the reduction will encourage those the highly paid to come here from Europe and North America; while high earners in Scotland, where taxes remain higher, will also have an incentive to move. The reduction in the top rate should also encourage those in England who are highly paid to take on more employment. If so, the tax take from this cohort will increase, just as it did after George Osborne’s reduction of the top rate from 50% to 45% in 2011. The ultra-rich, meanwhile, will continue to benefit from lower-rate tax contracts struck with HMRC to persuade them to base themselves in the UK. There is one law for the international jet set and one for the hoi polloi, including the merely highly paid.

The removal of the cap on bankers’ bonuses does not necessarily raise their earnings, but returns them to a more sensible pay system of fairly moderate fixed salaries topped up with big bonuses in the good years.

In the bad years, they can be fired more cheaply and their held-over bonuses cancelled, if generated from false profits. The cap has forced banks to raise salaries, made it expensive to fire them and encouraged bankers to work overseas. The decline of the British banking sector in recent years may not be a coincidence.

The cancellation of the increase in employees’ National Insurance from 12% to 13.25% and from 2% to 3.25% for earnings above £50,000 favours the well paid monetarily, but not relatively. That the top rate of taxation was to be 48.25%, not 45%, is universally ignored.

The increase in the threshold at which National Insurance has to be paid from £9,568 to £12,584, announced in June, benefits the low paid. The elderly, even if still working, do not benefit from the cancellation as national insurance is not paid above the state retirement age of 66.

The 1.25% increase in employers’ contributions is also cancelled. This is generally described as a tax on business, but in reality, it is another tax on employees. Its rise would have increased employment costs, which for many organisations, particularly in the public sector, would have fed through into lower pay rises. The cancellation of the increase will reduce the funding pressure on the public sector, notably the NHS, which is by far the UK’s biggest payer of National Insurance.

The effect on investment of keeping corporation tax at 19% rather than increasing it to 25% is hard to gauge, but it certainly won’t reduce it. Logically, the consequent increase in the return on capital should encourage businesses to invest in the UK rather than elsewhere, but there are many other factors influencing investment. Lovers of round numbers, like me, will regret the missed opportunity of standardising the rate of VAT, income tax and corporation tax at 20%.

It was left to the Institute for Fiscal Studies to point out what was not in the Budget: the raising of tax thresholds. These – both the personal allowance and the higher-rate threshold – were frozen for four years in the 2021 Budget.

Given the subsequent acceleration of inflation, this is a far more swingeing increase in taxation than was ever expected. In addition, the withdrawal of the personal allowance between earnings of £100,000 and £125,400 continues to mean a marginal rate of tax of 60%, plus 2% national insurance.

The cancellation of previously announced tax increases is not really a tax cut, and the freezing of thresholds still means a big increase in personal taxation.

Arguably, the effect of the acceleration in inflation makes Rishi Sunak’s tax increases unnecessary anyway. Inflation may also be helpful to the government in reducing government spending in real terms to the extent that departmental Budgets are set in nominal terms. So the Budget deficit should continue to turn out better than expected.

Whether the measures will lead to a significant increase in growth is a moot point. Lower taxes and a squeeze on the public sector probably more than balance out the negative impact of higher interest rates. In any case, ultra-low rates encourage the wrong sort of growth. There is much talk of the need to increase stagnating productivity in the UK, but productivity in a service-orientated economy is very hard to measure. The data could be significantly understated.

Raising productivity

The area where there is significant scope to raise productivity is in the public sector, notably in the NHS. Productivity growth (better healthcare for the same money in real terms, in other words) was achieved in the 1990s, but subsequently went into reverse. An increase in real resources no longer results in better outcomes overall. Reforming the NHS will be a major – and probably – impossible challenge.

The good news for the government is that natural-gas prices are falling, so the cost of the energy price cap, feared to be at least £100bn just a few weeks ago, may turn out to be much less and maybe nothing at all. If so, further tax cuts, including a raising of tax thresholds, will be on the cards. Will this save the government’s re-election prospects? That is a matter of opinion. I suspect that voters distrust governments that pledge to raise taxes only on the rich, knowing that when that fails to raise revenue, they too will have to cough up.

Tax cuts are popular because £1 in your pocket is worth more than money spent invisibly on public services. But these are not tax cuts. Sunak’s tax increases constituted political suicide; this Budget means the government is now in with a chance – energy prices, the economy and much else permitting.

“The world has been hooked on cheap money for years. Now we’re witnessing what withdrawal looks like,” says Randall Forsyth in Barron’s.

Last week, central banks from Scandinavia to Mongolia and from South Africa to Indonesia raised interest rates. America’s Federal Reserve delivered its third successive three-quarter point interest-rate hike, while the Bank of England raised interest rates by half a percentage point to 2.25%. Switzerland became the last European central bank to end its experiment with negative interest rates, leaving Japan as the only big economy where rates are still below zero.

Markets have swooned, with America’s S&P 500 stock index falling to its lowest level of the year so far on Monday. Oil prices have hit their lowest level since January on expectations of weaker demand.

Bond-market pain

“We’re living through… the most truly global attempt to tighten financial conditions in memory,” says John Authers on Bloomberg. “With 2022 not quite three-quarters over, this is already the worst year for [US Treasury] bond investors in six decades.” The yield curve, a measure of the gap between yields on US ten-year and two-year government bonds, has reached its steepest inversion “in more than 40 years”. Previous inversions have heralded a recession.

It has been clear for some time that monetary policy would need to tighten, but traders are only slowly waking up to the implications for overpriced equities, says James Mackintosh in The Wall Street Journal. “Markets are doing what they always do, hoping against hope that there’s no recession, or at least a very mild one, right up to the last minute.”

Fed policymakers have made clear that more hikes are in the pipeline, says Aaron Back in the same paper. Fed chair Jerome Powell describes the US labour market as “extremely tight”, a sign that the economy is still running too hot. US central bankers want “to see the economy slow significantly, even if that involves some pain”. Yet the bulls may still have a point: “the inflation... Powell is contending with isn’t nearly as entrenched as that of the 1970s. So a recession isn’t a sure thing and, if there is one, it might not be very deep or prolonged by historical standards”.

Investors are struggling to accept that their lost wealth isn’t coming back any time soon, says Katie Martin in the Financial Times. “The five stages of grief are denial, anger, bargaining, depression and acceptance.” Markets spent much of the summer in bargaining mode, when they “briefly took seriously the notion that central bankers might be gentle with rate rises”.

The current mood in stocks is somewhere between depression and acceptance. The latest round of global rate rises “has demonstrated, as if it were not already obvious, that declines in asset market valuations are simply not going away”.

The annual conclave of central bankers at Jackson Hole, Wyoming, is usually only of interest to the nerdiest of market watchers and economists who relish the micro-analysis of the carefully scripted wording of speeches and press releases. But this year was different.

Having raised interest rates this year by 2.25% to a target range of 2.25%-2.5%, the Federal Reserve, America’s central bank, had been expected to “pivot” to a more dovish stance. This might mean that the 0.5% increase in September would be the last, or that the increase would be 0.25%, or that there would be no increase at all.

Instead, Jerome Powell, chair of the Federal Reserve, reiterated the need to bring inflation down by pushing up interest rates whether it caused economic pain to households and businesses or not.

Why the Fed has changed its mind on interest rates

What caused this apparent change of mind?

Not the rate of inflation, which fell from 9.1% in June to 8.5% in July while the core underlying rate fell to 5.9%. Inflation is expected to have fallen further in August and economic indicators point to a further fall in the coming months.

Instead, Powell appears to have reacted to the bond market. The yield on ten-year US Treasury bonds rose from 1.5% at the start of the year to a peak of 3.5% in mid June before falling to 2.6% at the end of July. Since then, it has risen to 3.1%, indicating that while bond yields may accept the current downward trend of inflation, they are not convinced that it will fall back to 2% and stay there.

The gap between inflation-protected and conventional bonds, regarded as a good indicator of inflation expectations over the next ten years, rose from 2.3% to 2.6% so the credibility of the Fed was at stake. The Federal Reserve, it now seems, is committed to a monetary policy that will satisfy the bond market.

The “bond vigilantes”, a term invented by economist and market analyst Ed Yardeni in the 1980s to describe a world in which bond investors drive monetary policy, are back.

It is notable that the 24% fall in the S&P 500 index between the start of the year and mid June, a period in which corporate earnings continued to rise at a brisk pace, coincided almost exactly with the rise in bond yields. So did the 17% rally to mid August, and so did the subsequent 8% fall.

Stockmarket investors are not particularly concerned about the effect any recession would have on corporate earnings because they know that corporate earnings will recover with the economy. They are much more concerned with the risk of higher bond yields, which result in lower interest rates.

If bond investors are happy, stockmarket investors are happy

This goes against conventional wisdom which claims that recessions are “bad” for stockmarkets, so markets will be undermined by higher rates. Investors want central banks to do whatever it takes to knock inflation back, regardless of the short term economic consequences. If bond investors are happy, stockmarket investors will be happy too, and the yield on ten-year US Treasuries is the best indicator of investor confidence.

Consumers and businesses do not like paying higher interest rates on their borrowings, but they like inflation even less. They do not want a recession with its attendant risk of unemployment and falling living standards but will probably accept some short term sacrifice if the result is lower inflation and interest rates, combined with a return to growth in the longer term. We are all inflation vigilantes now.

The reason US inflation is falling – and hence the economy is in good shape – is down to energy. Fracking has made the US self-sufficient in oil and gas, in addition to which the US is bordered by two hydrocarbon-rich friendly countries. Europe, in contrast, trusted its future energy needs to Russia, succumbing to anti-nuclear superstition and a Russian-backed campaign against fracking. There are few signs of policy change.

Britain lies somewhere in the middle with plenty of hydrocarbon reserves, but an aversion to exploiting them.

The UK seems intent on making the problem worse. The Bank of England has proved slow to raise interest rates with the result that sterling fell 5% in August alone. This promises to exacerbate inflation and worsen the outlook for the UK economy.

The government has the fiscal headroom to alleviate the downturn, but all the media and popular pressure is for short-term fixes which will make the problems worse.

The imperative is to reduce demand for hydrocarbons and increase supply, not to finance short-term hand-outs through borrowing and production taxes. We will soon see whether the new government will rise to the challenge.

The world follows where the US leads

Ed Yardeni notes that falls in US GDP in the first two quarters match the definition of recession but he expects the data to be revised upwards, helped by strong employment. He doesn’t “expect any downturn over the rest of the year and/or next will be severe enough to qualify as an official recession” but instead sees the continuation of a “rolling recession” passing through different sectors and regions.

As a result, he expects “S&P 500 earnings growth of -5.4% and -3.8% year-on-year in quarters three and four” which still means growth of 3.1% for the year as a whole and 9.3% next year.

That puts the S&P 500 on 18.4 times this year’s earnings and 16.9 times next. Whether that is cheap or expensive depends very much on the Federal Reserve dancing to the tune of the bond vigilantes. If it does so, US Treasuries may even be reasonable value.

The US accounts for 62% of the global stockmarket, while Japan, where inflation is just 2.5%, is also in good shape. The countries facing serious economic challenges, including the UK, the EU and China, make up less than 20% of the index. As the US goes, so will world markets.

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“Gone are the days [when] we could rely on a Powell-backed equity rally,” says Ipek Ozkardeskaya of Swissquote Bank. Stockmarkets are used to central bankers offering them goodies when the economy weakens, but last week US Federal Reserve chair Jerome Powell instead threatened to remove the punchbowl. He made clear that “inflation must come down even if it means pain for households and businesses”.

The annual “central bankers’ conclave” in Jackson Hole, Wyoming, sees the world’s most powerful monetary policymakers gather to share “the latest reading from their models, crystal balls or chicken intestines”, says Irwin Stelzer in The Sunday Times. In 2021 Powell declared at the meeting that high inflation “was likely to prove temporary”. What a difference a year makes. With US inflation at 8.5%, he will now do battle with the inflationary tiger. Markets tumbled after Powell’s speech, with the S&P 500 and Nasdaq Composite falling 3.4% and 3.9%.

Japan’s Nikkei slipped by 2.7%. US interest rates are currently between 2.25% and 2.5%. Markets now expect the Fed to raise rates to “3.8% by February 2023, up from expectations of 3.3%” at the beginning of August, says the Financial Times. Powell and other senior global central bankers pushed back strongly against market bets that they will start cutting rates next year, says Bloomberg. Instead, they “expect to raise rates and hold them at elevated levels” until inflation is back under control.

Learning from history

Powell was also at pains to dash hopes that July’s softer inflation figures would herald a Fed pivot, says Ian Shepherdson of Pantheon Macroeconomics. “A single month’s improvement falls far short of what [we] need to see before we are confident that inflation is moving down,” he said. Powell noted that “the historical record cautions strongly against prematurely loosening policy”. Powell is referring to the 1970s, say Thomas Sargent and William Silber in The Wall Street Journal. When inflation spiked to 11% in 1974 thenchair Arthur Burns reacted by hiking rates to more than 12%.

That move temporarily brought inflation under control, but the resulting recession and unemployment then prompted Burns to ease too quickly. He cut short-term rates in half, causing a second price spike that eventually saw inflation peak at 14.6% in 1980. The Fed remained on the back foot in the fight against the “great inflation” until the early 1980s.

Powell will be keen not to repeat that experience, says Russ Mould of AJ Bell. Low unemployment and few “signs of distress in the wider US economy and financial system” from hikes so far will probably embolden the Fed to “keep monetary policy tighter for longer than financial markets currently expect”.

“The extreme pessimism of the first half of 2022 seems a distant memory” on Wall Street, says Nicholas Jasinski in Barron’s. “War in Europe, runaway inflation” and “a behind-the-curve Federal Reserve” saw US stocks suffer their worst first half in more than 50 years.

Yet the S&P 500 index gained 17% between its June lows and 16 August, while the tech-heavy Nasdaq rose more than 20%, a milestone widely considered to herald a new bull market. The FTSE 100 rose 7% over the same period.

Why confidence has grown

This summer’s rally has proceeded in two stages, says Thomas Mathews of Capital Economics. “Until early August” it was driven by “unwinding of expectations for Fed rate hikes” amid bets that a slowing economy would soon show inflation the door. Since then, growing confidence that the US is heading for a “soft landing” in the wake of solid corporate results and continued strength in the jobs market has kept the bulls running.

“The S&P has retraced 50% of its losses from the 3 January high to the 16 June low,” says Bob Pisani for CNBC. That has encouraged some to argue that the bear market is over. “History reminds us that the S&P 500 never set a lower low in any post-World War II bear market after recovering 50% of that peak-to trough decline,” says Sam Stovall of CFRA Research.

There are other reasons to hope this rally might stick, says Tom Stevenson in The Telegraph. Rather than being driven by the technology and growth stocks that led the post-pandemic upswing, market leadership has shifted towards “utilities, energy and dividend paying shares”. That makes this feel like a fresh bull market rather than a rehash of the last one.

On the other hand, this summer’s rally has brought renewed interest in meme stocks such as Bed Bath & Beyond, a market mania with a distinctly 2021 flavour. Speculative options trading, “a popular vehicle for retail investors looking to place leveraged bets in hopes of outsized gains”, has also made a return, says Saqib Iqbal Ahmed on Reuters. Ten-day average daily trading volume of single stock options is “at a more-than six-month high”, according to data from Trade Alert.

Investment bank traders warn that the bounce has been “driven by hedge funds unwinding bearish bets”, say Eric Platt and Ortenca Aliaj in the Financial Times. This summer’s rally has forced hedge funds to cover “short bets” they had made earlier this year, but that doesn’t suggest there is much “conviction” around that this is a new bull market. “There is no real follow-up from long-only or fundamental buyers, who are largely on the sidelines,” says Justin Cummings of Savoy Capital.

Investors seem to be pricing in a lot of good news, says The Economist. “Inflation is far from being vanquished” and the Fed, “having been late to react to the inflation surge… is unlikely to turn on a dime”. China’s economy is slowing and Europe is heading for a gloomy winter. And as experienced investors will tell you, “most past market downturns included plenty of breathtaking bear-market rallies before... prices resumed their downwards march”.

Has US inflation finally peaked? Annual inflation fell to 8.5% in July, down from 9.1% the previous month. The fall was driven by a 7.7% month-on-month slump in US petrol prices in July. The data prompted traders to conclude that the Fed might not have to raise interest rates as aggressively as feared. Strong employment data – the economy added half a million jobs in July – has also encouraged bets that the economy may dodge a recession. The S&P 500 index has gained 11% in a month.

Even if the US has passed the peak, it will be some time before inflation comes back down to earth. As Campbell Harvey of Research Affiliates points out, there has been so much inflation in recent months that even if prices now remain flat for the rest of the year – an unlikely scenario – then headline annual inflation will still be at more than 6% in December.

Inflation is structural, not transitory

And structural forces (such as de-globalisation) are pushing prices higher. The data “gives as much reason for consternation as for celebration”, says The Economist. Annual core inflation – a measure that strips out volatile food and energy prices – is running at 5.9%, the same as the previous month.

The strong labour market is fuelling pay growth, with wages up by an annual 5.2% over the past three months. That suggests price rises are becoming embedded in the economy, heralding “structural” rather than “transitory” inflation. While the headline numbers were good, “inflation remains both broad-based and far above the Fed’s target”, says James Mackintosh in The Wall Street Journal. Investors’ optimism is misplaced – “there’s no sign the Federal Reserve will change its mind and agree with investors that rates should come down again next year”.

Equity traders are also failing to price in the effects of the coming slowdown on corporate earnings, which they blithely expect to continue rising this year and next. Bond markets seem to be expecting “one sharp round of tightening –comprised of a rise in short-term interest rates to just above 3%” that will “be enough to bring inflation down to 2.5% with stable growth and no dent in earnings”, says Bob Prince of Bridgewater Associates.

That looks optimistic, says John Mauldin in his Thoughts from the Frontline newsletter. “Bond investors seem to have a great deal of faith that the Fed… will make inflation recede sharply and soon.” Markets usually know better than individuals, but there has been so much central bank intervention in the bond market that arguably “it is no longer a market in any meaningful sense”. Central bankers are likely to lose their nerve when recession bites, slashing rates too early even while inflation is not back under control. The result? “Extended stagflation is our most likely destination.”

“The only function of economic forecasting is to make astrology look respectable,” said JK Galbraith. Predictions about stockmarkets, earnings or macroeconomic trends can be safely ignored, especially if you are a picky Virgo like me. That is why we haven’t been too fazed by the Bank of England’s forecast of a 15-month recession. Its record is no better than any other forecaster’s, to put it charitably. A year ago it thought inflation would peak at 4%. Now it thinks inflation is heading for 13%. It was too gloomy about the impact on GDP of the Brexit vote and failed to predict the 2008 financial crisis. All official forecasters did.

The US Federal Reserve said in January 2008, when the credit crunch was spreading fast, that the US would expand by up to 2% in 2008 and up to 2.7% in 2009. But GDP shrank by 0.3% in 2008 and 2.8% in 2009. Andy Haldane, the former chief economist at the Bank, compared economists’ failure to predict the crisis with Michael Fish missing the 1987 storm.

The bigger picture is that the stagflationary hurricane is well and truly here, regardless of whether the economy ends up shrinking for several months or not. The Bank, like its counterparts elsewhere, has been caught on the hop by inflation. Now it will try to subdue it by hiking interest rates, and talk has turned to what measures could alleviate the pain and bolster growth – state payments to help with energy bills and tax cuts, principally.

Overlooking the key ingredient

The fuss over the downturn and fiscal stimuli misses a key point, however. The measures being discussed relate to the demand side of the economy, but it is improving the supply side that will do the most good over the longer term. The last time we escaped stagflation, in fact, reforms to improve the productive capacity of the economy, such as privatising state behemoths and taming trade unions, helped pave the way for a lasting recovery. Those reforms helped bolster productivity, and we urgently need to do that again. “Productivity isn’t everything, but in the long-run it is almost everything,” as economist Paul Krugman put it.

The more effectively an economy uses its workforce and capital, the richer it will get. But Britain’s productivity growth is abysmal, as Neil Shearing of Capital Economics points out. Average output per hour worked rose by just 0.7% a year in the ten years before Covid-19, a far cry from the 1.7% average in the five years to 2008 and the 2.8% seen in the 1980s. Productivity growth hasn’t been this low since the start of the industrial revolution, says David Smith of the Sunday Times.

According to The National Institute of Economic and Social Research, if productivity had grown by an annual 2% in the past decade, the average worker would now be £5,000 better off.

So what’s the problem? What isn’t? It’s a toxic cocktail of shabby infrastructure, low business investment, poor skills, and over-centralisation (which implies less scope for a region’s institutions to galvanise growth and innovation, among other things). There is no way of cutting this Gordian knot, but you have to start somewhere, and it would have been helpful to hear from the Tory leadership candidates how they might approach it. Liz Truss may present a plan when she wins. But don’t hold your breath – and perhaps top up your gold.

Come and see Merryn at her Edinburgh Fringe show at Panmure House (once home to Adam Smith), which runs from 25 to 28 August. Guests include MoneyWeek favourites Russell Napier, James Ferguson and Edward Chancellor. Book your tickets here. All proceeds go to the upkeep of Panmure House.

I thought today I would check in on some charts that I haven’t looked at in a very long time.

That is the Dow-gold ratio - the long-term ratio between the price of gold and the value of 30 of the most prominent companies in the US, aka the Dow Jones Industrial Average.

What is the purpose of this exercise?

Effectively, you are measuring stocks in money that hasn’t been debased. There are many who argue that the gold price is suppressed, but let us put such thoughts to one side and accept that, even if it has, gold’s value - its purchasing power - has preserved way better than the US dollar’s, or indeed any national currency.

In this instance, gold is a better unit of account, and the act of valuing stock prices in gold can tell you, quite quickly, which asset is cheap and which is expensive.

So here, courtesy of Nick Laird over at goldchartsrus, is the Dow-gold ratio since, get this, 1800.

A major change in the evolution of money

There is a lot to take in here.

The period from 1800 to 1913 is of considerable historical interest, but it is fairly irrelevant to use as investors. Gold was money in the 19th century and the US stock market was young.

Nevertheless we observe how the value of America’s companies grew incrementally over the course of that century, but in a relatively measured way. There was not the volatility that came with the post 1913 era of central banking.

When the black line is rising it means that stocks are rising in price, relative to gold.

220 years- Dow/Gold Ratio

Turning next to the post 1913 era. Nick has drawn a vertical red line at 1913 because that is when the US Federal Reserve Bank was formed. The following year the UK, France and Germany all abandoned their gold standards to print money to pay for World War One.

The period saw a major sea change in the evolution of money and banking.

You can see that there were three major highs - in 1929, in 1971 and in 2000. Again these were all years that saw major financial turning points. 1929 was the top of the stock market before the Great Crash. 1971 was the year President Nixon took the US off the gold standard. And 2000 was the year DotCom peaked while gold came to the end of a 20-year bear market.

Also notable are the years 1932 to 1933 - the low in stocks in the Great Depression and the time President Roosevelt confiscated Americans’ gold and then devalued the dollar.

And 1980 too. That was the year that the great gold bull market of the 1970s came to end. Gold spiked with the Iranian hostage crisis to $850/oz and, with Fed chief Paul Volker’s raising the Fed funds rate to 20%, the era of inflation came to an end and the stage was set for the next bull market in stocks.

Here is the last 120 years in close up.

120 Years - Dow/Gold Ratio

With the Dow today at 33,800 and gold at $1,790/oz it takes 19 ounces to buy the Dow. So gold is right in the middle of the range. It is neither expensive nor cheap. The same could be said of stocks.

There are many who argue that the Dow-gold ratio is going back to 1, as it did in 1980. That return could take many forms. There could be an extraordinary bull market in gold, inflation in the US dollar and stocks could simply remain flat. In such a scenario gold would have to go to $33,000/oz.

I don’t think that is going to happen, unless the US suddenly decides it is going to settle its debts with its gold and revalues the price upwards. Unlikely.

I suppose it’s possible that some deflationary panic, a war or a global pandemic, could send stocks tumbling by 50%, while gold itself goes up 10 times. Again unlikely. But these are the kind of scenarios we would need for that ratio to go back to 1.

I just don’t think it’s realistic. It might have been normal in the 19th century, but not today.

On the other hand, a runaway bull market in stocks could see the Dow double over the next three years while the world becomes even less interested in the analogue asset that is gold sending the price back to $1,300.

In that kind of scenario you would have a Dow-gold ratio at 50.

It would be above and beyond the green confidence band on the chart at extremities, but I have to say I would have thought a Dow-gold ratio at 50 is more likely than at one.

But based on the chart above, gold is probably a sell below 10 on the ratio.

Asset allocation for the next market cycle

Alternatively, here is the S&P 500-gold ratio.

With the S&P currently at 4,120 and gold at $1,790/oz that ratio currently stands at 2.3.

100 Years S&P 500/Gold Ratio

This a ratio that could easily go to one. If the S&P comes off a little bit, say 25% to 3,000 while gold has a big run to $3,000 - which is not such an impossible number - the S&P-gold ratio will hit one. It’s unlikely, but not impossible.

Similarly the S&P could go to 7,000 or more as gold falls to $1,500. Then you’ve got an S&P-gold ratio at 5. Not such an impossibility.

Stocks have been rising relative to gold since 2011, when gold last peaked. In the last three years they’ve wobbled a bit.

Where’s that one headed? One or five? Or do we stay where we are around 2?

It’s a big call. But it’s an important one to get right, as you allocate assets for the next cycle.

And if you happen to be in Edinburgh this week, please come and see my show How Heavy?, a lecture with funny bits about weights and measures. It’s running at the Fringe until Sunday. You can get tickets here.

Today at noon, we get the Bank of England’s latest interest rate decision.

The main UK interest rate is currently sitting at 1.25%. Markets expect the Bank to raise that to 1.75%. That half-point increase would be the biggest rise since 1995 (and the Bank wasn’t even independent back then).

(For perspective, they were starting from a much higher rate at that point – the Bank rate was above 6%, while inflation was sitting at less than 3%.)

The expectations for a half-point hike are driven mostly by the action of the Bank’s peers. The US Federal Reserve and the European Central Bank have both been raising rates more aggressively than expected. (The ECB raised them all the way to 0%!)

So some argue that the Bank should be raising rates aggressively, to keep up.

There’s a perfectly reasonable argument for all of this. Inflation is really high compared to interest rates. If it stays high, then inflation expectations go up too. If people expect inflation to stay high then it changes their behaviour. Same goes for corporations. Everyone starts acting as if inflation will stay high, and it becomes a self-fulfilling prophecy.

That’s the theory anyway. Personally speaking, I’m not convinced by the whole “expectations” idea, which falls into the wishy-washy “feelings” side of economics. People’s economic actions don’t stem from mood swings, they are bedded in “real” conditions and circumstances facing them on the ground.

If you start with that assumption, then the concrete problem with inflation being above a certain level is that it makes planning ahead much harder. This in turn makes decision-making throughout the economy more short-termist and therefore less efficient. You move from “just-in-time” to “just-in-case”.

And yes, that becomes a self-fulfilling prophecy too. But if you at least acknowledge that it’s based on what is fundamentally a mechanical problem in the real world, then you can think about how to address that problem. This explains why, for example, Walmart is struggling with inventory management right now, even though its expertise in inventory management must surely put it among the best in the world.

Central banks can no longer play the saviour

Anyway, there’s a bigger issue here.

The reality is that the Bank probably doesn’t have a great deal of choice. Having rates sitting at 1.25% when inflation is heading into double-digit territory is just untenable. And if the Bank doesn’t at least meet market expectations – no guarantee when Andrew Bailey is in charge – then that would send the pound lower, which would only exacerbate the problem.

But a rate rise to 1.75%, or 2%, or even 2.25% is not going to do a lot to make anything better for anyone.

The real problem is that, over the last 20 years or so, we have come to rely on central banks far too much to do all the heavy economic lifting. And during that period, they haven’t really been fighting inflation – they’ve been fighting deflation.

This means that when the economy has run into recessionary times, central banks have always been poised to cut interest rates, not raise them. None of that has stopped recessions from happening. But certainly during 2008 and the 2020 pandemic and countless brief market stumbles in between, cutting rates has been seen as a bit of a magic wand – not just for markets, but for the wider economy too.

We are now in a situation where central banks simply cannot help in this way. If they really want to stop inflation in its tracks, they’ll have to raise rates so high that they inflict a recession which is even harsher than the one which is more than likely already heading our way.

So what does all that mean? Well, once upon a time, we might have argued that you could just do nothing. Let the economy sort itself out. High energy prices will squeeze consumer demand. A recession will mean less competition for workers, which will keep a lid on wages. Getting interest rates to a point where they are a little more “normal” will help savings to balance out debt somewhat.

But after such a long time of getting used to someone coming along to “do something” when economic pain is on the horizon, I don’t think we’re going to see a laissez-faire attitude spring up now. Instead, the obvious candidate to “do something” is the government.

“Do something!”

The government, which will either be led by Liz Truss or Rishi Sunak, is definitely going to face calls to “do something” (indeed it already is) given how painful the energy squeeze is about to get.

As things stand, it’s hard to exaggerate how bad the shock looks like it could be. Households are facing a doubling of energy bills compared to what they’ve been used to. That is a huge amount of money and it will not be politically popular, to say the least.

Iain Martin in The Times (hardly a “big government” guy) goes so far as to argue that the pending energy crisis could “become a poll tax moment”.

So what does that mean in practice? In practice, it means intervention. On the upside, you might find that you get more help with your energy bills this year (and maybe next) than is already on the cards. On the downside, that money is going to have to come from somewhere.

You need only look at headlines in recent days as companies in the energy sector have reported record profits. You can debate the financial literacy of all this for days (there isn’t any). But that’s not really useful to an investor.

I suspect that further windfall taxes of some sort are likely to be considered (although they’re probably more likely under Sunak). And that’s under a right-leaning government.

It doesn’t mean you should avoid energy production – we’re going to need a lot more of it after all. But it does mean it makes sense to be diversified both within and outside of the UK. Dominic suggested some wide-ranging funds for playing oil here.

Recession? What recession? The US economy shrank at an annualised pace of 0.9% between April and June, its second successive quarterly contraction. In many countries that would meet the definition of a recession, but with unemployment close to a 50-year low and two vacancies for every jobseeker in May, the White House has rejected the label. “That doesn’t sound like a recession to me,” says president Joe Biden.

“The official designation is determined by eight economists” at the National Bureau of Economic Research, who also look at measures of jobs growth, income and spending to make a recession call, say Nicole Goodkind and Tal Yellin for CNN. They don’t think this slowdown qualifies.

Beyond the technical arguments, “what’s clear to everyone is the economy is slowing, prices are rising at their fastest pace in decades, and the housing market has started cooling as the Fed raises interest rates aggressively”, says David Gura on National Public Radio. Around 65% of US voters think the country is already in recession.

Investors are too bullish

That hasn’t dampened investors’ spirits, however. The S&P 500 plunged 21% in the first six months of the year, but rallied 9.1% in July for its best monthly showing since November 2020, say Kate Duguid and Naomi Rovnick in the Financial Times. The tech-heavy Nasdaq Composite index gained 12.3%. Last week the US Federal Reserve hiked interest rates another three-quarters of a percentage point to a range between 2.25% and 2.5%. Yet investors increasingly think that a weaker economy will cool inflation and see the Fed relent fairly soon, says John Authers on Bloomberg. “That’s an unlikely scenario” that suggests a misplaced confidence in the Fed’s ability to manage the inflationary storm without reducing corporate earnings. July’s gains look like a bear-market rally, a moment when “it appears that all the selling is over and that it’s safe to take risks once more”, only for markets subsequently to plunge once again.

Bear-market rallies are not uncommon, says Robert Armstrong in the Financial Times. “I count four or possibly five in the 2007-2009 downturn.” There were also “three big ones, all of around 20%, interspersed within the 2000-2003 crash”. While this rally principally reflects “a softening of inflation” and interest-rate expectations, investors also appear to think that the US is heading for “either a shallow recession or no recession at all next year”.

Wall Street is being unduly optimistic, says Russ Mould of AJ Bell. Analysts are still forecasting increases for overall S&P 500 earnings in 2022 and 2023. That looks a “stretch” given soaring inflation and “sagging growth”. Note that “US corporate profits stand at record highs not just in margin and absolute dollar terms, but also as a percentage of GDP”, leaving limited room for further progress. While US valuations have come down this year, they still look expensive on the crucial cyclically adjusted price/earnings (CAPE) gauge. “Any time the CAPE ratio has stood at the current level, subsequent ten-year compound returns from US equities have invariably been negative.”

The Federal Reserve, America’s central bank, raised interest rates in the US by three-quarters of a percentage point yesterday. That’s the second month in a row. The federal funds target rate is now 2.25% to 2.5% (it’s a range, rather than one number as with the Bank of England).

Once upon a time, not so very long ago, the idea that the Fed would be pumping what the market once viewed as six months’ worth of rate rises into just two months would have had people expecting the end of the world.

And certainly markets haven’t exactly been enjoying the ride. But the Fed has persisted.

Thing is, yesterday, alongside the 0.75 percentage point rise, we also got a whisper of a hint that the Fed might decide to ease up a little, depending on what happens next.

To be more specific, Fed boss Jerome Powell said “it likely will become appropriate to slow the pace of increases”.

That hint was sufficient to send the S&P 500 up 2.6% and the Nasdaq up by 4.1%.

The thing is, though, Powell also warned that “another unusually large rate rise” could be appropriate too, depending on the data.

So is the market falling for wishful thinking? I can’t help but think that it might be. Here’s why.

The Fed now feels financially omnipotent

I was listening to Bloomberg’s Odd Lots podcast yesterday. The guest, former senior Federal Reserve trader Joseph Wang, made a point which really made me rethink my view on central banks.

Here’s a bit of context.

For decades now, the core assumption about central banks is that they will intervene in markets if they fall fast enough or far enough. This tendency was best known as the “Greenspan put”, after Alan Greenspan, the Federal Reserve chair who first put it into practice. It was never official policy, but Greenspan’s habit of cutting interest rates at any sign of trouble certainly bred an element of complacency.

This belief that the Fed has a pain point at which it will act to “save” the market is still apparent. Investors keep thinking that a turning point is coming any time now, which explains why they all alighted on Powell’s words.

But why did the “Greenspan put” exist in the first place? It was because Greenspan was worried about systemic threats. For example, hedge fund LTCM was bailed out in 1998 because of Greenspan’s fears that a collapse of the highly-leveraged fund would create a chain reaction and bankrupt most of Wall Street.

In 2008 we had the financial crisis, and the Fed learned the hard way that some institutions were too big to fail. As a result, in the decade following, the Fed made sure it only took baby steps and tried never to do anything to take the fragile market by surprise.

But all through this process, the central bank was creating more and more systems by which it could intervene more and more aggressively and in more and more markets. By the time the 2020 pandemic panic came round, the Fed was able to declare that it would literally buy junk bonds, effectively scrapping bankruptcy (should it wish). Using swap lines, it also did a great deal to prevent overseas markets from blowing up.

So in effect – and this is Wang’s point – the Fed now feels powerful enough (and you can see why) to be relatively confident that no crisis can be big enough to be systemic anymore.

The “Greenspan put” created massive moral hazard. The fact that the market could rely on being bailed out every time it took too many risks and took things too far, meant that it just kept on taking risks and pushing things too far.

The irony now is that, having underwritten everything, the Fed may have created a different kind of moral hazard. It now feels that it can stop any crisis in its tracks. And as a result, it can raise rates as much as it likes (or at least as much as it takes to tackle inflation) without breaking anything.

In turn, that implies that the Greenspan put is not only dead and buried – it implies that the Fed no longer really cares about the market reaction except in as much as it either tightens or loosens financial conditions.

Something always breaks

That’s a very different world for investors to be operating in – an actively market-hostile (or at least market-agnostic) Fed rather than one which is pandering to every panic and tantrum.

Perhaps more importantly – something always breaks. Not sure what it would be this time around, but something in currency markets (if the dollar keeps surprising everyone) or sovereign debt markets (as Jonathan Compton wrote in a recent issue of MoneyWeek, we’re overdue a wave of defaults) seem likely candidates.

We’ll see. In any case, for now, markets might keep bouncing given the grimness of sentiment out there. But I’d be surprised if the Fed is pleased about the reaction to yesterday’s press conference. The reality is that until inflation shows genuine signs of coming under control, the bias towards tightening won’t relax – and if markets don’t get the message, the Fed might have to act even more aggressively.

At first, surging inflation was “transitory”. Then it went on too long to be transitory. So the word “transitory” was dropped (officially, by the Federal Reserve) around the end of last year.

However, markets still haven’t given up hope.

You can understand why. Commodity prices have crashed this year. Oil prices haven’t crashed, but they have stalled.

And most of the market (almost certainly correctly, as I’ll explain below) expects a recession in the imminent future.

So we moved into the phase where every month was surely going to deliver the evidence that the worst inflation reading was behind us, and at that point, team “transitory” would have been proven correct, if a little early.

I mean, maybe it’ll happen one day. But yesterday was not that day.

Inflation just isn’t calming down

I realise the majority of our readers are UK based. But one of the features of a globalised financial system is that what’s going on with the other big players really matters for investors everywhere. Not least when the biggest player – the US – also controls the world’s reserve currency.

We used to run on a gold standard. Now we run on a dollar standard. So just as the tides of gold flowing around the world (or at least, moving from one end of a vault to another) would play havoc with markets and economic policy everywhere, so the motions of the dollar now do the same.

Put more simply, what happens in the US really matters for all our portfolios.

Yesterday, US inflation hit another fresh 40-year high. It also beat expectations – yet again. In terms of crumbs of comfort – well, there weren’t any. Headline prices rose at an annual rate of 9.1% in June, compared to 8.6% in May.

John Authers writing for Bloomberg rather summed it up when he pointed out that US inflation is now higher than Mexico’s. He also notes that “sticky” inflation (as measured by the Atlanta Federal Reserve bank) is now back to 1970s levels.

None of this is to say that inflation won’t peak at some point – of course it will. But those who hope that just because copper, say, has plunged into a bear market, that we’re on the verge of actual deflation, are going to be disappointed.

So what’s the effect of all this on markets?

Well, this is where it gets a little complicated. And to give you my view before I explain in more detail, I think the market reaction shows that investors are still focusing on the wrong problems.

Markets are expecting – even hoping for? – a recession

Markets are already predicting a recession. This is understandable and the odds suggest that they are right to do so. Why do I say that?

Well, people will tell you that no economic timing indicator is perfect. That’s absolutely true, nothing is.

But an inverted yield curve is the closest thing we’ve got to a perfect indicator and the reality is that it has a superb track record of predicting recession. (You can read what an inverted yield curve is here).

Given how solid its post-war record has been – predicting every recession correctly with only one false positive in that entire time – it seems foolhardy to bet against it. I’ve seen this several times, and every time you get a swathe of articles and academic papers explaining why the yield curve might be wrong this time.

This inversion has been no different. But if you play the odds (and what else can you do as a sensible investor?), then betting against a US recession at this point is the wrong move.

Of course, none of this is much help in terms of your personal investing. You still can’t time the market using the inverted yield curve.

However, it does show why the market reaction yesterday was weirdly muted. Markets are already assuming that we face a recession. That recession will be caused, they believe, by the Federal Reserve raising interest rates until the pips squeak, basically.

Yesterday’s higher-than-expected inflation reading merely confirmed this existing view. That’s why the threat of a full percentage point interest-rate rise didn’t absolutely crater stocks.

Where it gets trickier is this: the longer-run belief is that the Fed will manage to squeeze inflation out of the system. And at that point, the central bank can cut rates, and everything will be – well, not exactly hunky dory again, but back to where it was.

You need only look at the performance of the more interest-rate sensitive “jam tomorrow” stocks in the last month or so. The ARK Innovation ETF, which is my go-to indicator for this stuff, is up about 20% in the past month (some would call that a bull market!).

There’s still a lot of volatility in there but you can see that investors are now looking forward to a time again when interest rates are falling, and their knee-jerk reaction is to buy the same stuff that they bought the last time.

This, by the way, seems a bit odd, given that growth stocks surely are not a good bet in a recession, but never underestimate the staying power of a trend.

Anyway – it seems to me that markets are setting themselves up for disappointment. It’s easy for the Fed to be relentless right now because employment remains high and the political pain is being caused by the soaring cost of living.

But how will it react if and when job losses begin and the cost of living is still stratospheric? And what will that all mean politically? And what will happen when recession fear starts to pass and as a result, commodity prices rebound sharply (because the current falls are arguably being driven partly by financial flows retreating and other temporary factors rather than because a flood of new supply has hit the markets)? ��

We’ll see. I’m not convinced inflation will be beaten that easily. And I suspect that, as a result, markets will be choppy and hard to navigate for a lot longer. What does it mean for you? Stick to your plan, have cash to take advantage of opportunities, and just be prepared for more turbulence. No heroics.