Economic Update: 21 July 2017
The Investment Management team round-up some of this week’s news.
The consumer price index (CPI), measuring the pace of rising costs for goods and services, fell to a rate of 2.6% from the previous month’s four year high of 2.9%. Inflation came in lower on the back of cheaper oil prices and electronics.
Inflationary effects are influential because they squeeze household incomes and wealth if wage growth and savings rates are not compensating. Currently we are witnessing lacklustre wage growth and interest rates at all-time lows, thus savings in deposit accounts are making a loss in real terms after adjusting for inflation.
The rate at which prices are rising affects the Bank of England’s (BoE) decision whether to change the existing interest rate. From an economic perspective, raising interest rates forms part of monetary policy management, and, under certain circumstances, raising them will act to put downward pressure on inflation (assuming they constrain demand for goods and services).
Responsibility for managing the rate of interest lies with the BoE’s Monetary Policy Committee (MPC). Their main objective is to deliver price stability; with low inflation, the target set currently at 2% (set each year by the Chancellor of the Exchequer in the annual Budget statement).
Inflation is above target currently causing much debate about the need to raise rates. However, as the latest published figure indicates inflation falling again, without any Central Bank intervention, has reduced the probability of higher interest rates in the short term. The consensus estimates that we have from analysts is the expectation of an interest rate hike by the end of the year was 50% on Monday, before the inflation measure was released, and 40% on Wednesday after the announcement.
Although an inflation rate above the 2% target is not considered desirable, the BoE operate with a 1 percentage point band either side of the central target, giving a degree of latitude. They acknowledge that inflation below 2% is just as bad as being above target. As you can see from the chart above, we only need to cast our minds back a few months to remind ourselves that the concerns bandied around back then related to inflation being too low.
The general conclusion for us is that with wage growth currently lagging the rate of inflation, and consequently dragging on consumer spending, it is likely to be difficult for the BoE’s MPC members to agree on pursuing higher interest rates without taking a risk on growth.
China Q2 GDP Exceeds Estimates
China continued to maintain its robust economic performance with the latest Gross Domestic Product (GDP) figures released for quarter two (Q2) exceeding forecasts. GDP increased 6.9% in Q2 from a year earlier, slightly ahead of estimates and matching the pace of expansion in the first quarter. Improving industrial output, higher retail sales and greater fixed-asset investments all contributed to China’s pick-up in economic activity.
China is an important contributor to global growth but is, itself, dependent on growth in the global economy. Encouragingly exports have begun to recover and this has been partly responsible for the strong rise in industrial production.
Despite a strong headline figure for growth in the economy, there are still concerns surrounding rising debt levels along with overcapacity in manufacturing sectors. Strong, and arguably speculative, property sector price performance has spurred growth. However, many now wonder if property prices especially those in the large cities are indeed in a bubble.
The National Bureau of Statistics said the growth figure indicates China’s economy has become “more stable, co-ordinated and sustainable”. Nevertheless, they highlighted that “there are still many unstable and uncertain factors abroad and long-term structural contradictions remain prominent at home”.
The central command structure which lies behind China’s economic performance has continued to confound critics. They worry about speculative monetary excesses spilling over and knocking the performance of the real economy off its present positive trajectory.
ECB & BOJ
Central Banks were again at the forefront of investors thinking this week, not just in the UK but in Japan and Europe. Both the European Central Bank (ECB) and Bank of Japan (BoJ) held press conferences where they outlined future monetary policy plans.
The ECB left its main interest rate unchanged and the ECB council was unanimous in not changing the quantitative easing guidance. Mario Draghi, President of the ECB, stated that “tighter financial conditions were the last thing that officials wanted”. He noted that there is still a degree of monetary accommodation needed for underlying inflation pressures to gradually build. Interestingly, he stated that the bank would be willing, if needed, to increase their asset purchasing programme (buying bonds to keep downward pressure on yields).
The only catalyst that will be seen as a sign that perhaps the bank should reduce its asset purchasing programme would be a consistent rise in inflation. However, the ECB is still waiting for inflation to catch up with the economy’s recovery (currently growing at 1.4%). The tone was somewhat different to what we saw three weeks ago, when Draghi noted that renewed reflationary forces would provide the room for adjusting the current stimulus.
The Bank of Japan has also maintained its vast monetary stimulus programme, along with delaying the time frame for reaching their inflation target of 2%, which is the sixth time it has been postponed under Governor Haruhiko Kuroda. The central bank now sees the target being reached by March 2020, five years after Mr. Kuroda’s initial timing. Japan’s struggle to meet its inflation target comes despite the bank raising its forecast of economic growth in the year ending March 2018 to 1.8%, up from earlier forecasts of 1.6%. With improving economic growth, inflation tends to follow suit, but this has not been the case in Japan where poor demographics (ageing population) and a high rate of savings has kept a lid on inflation. To try and induce higher prices the bank has targeted a yield for a 10-year government bond of zero percent and short-term deposit rates at -0.1%, along with an extensive bond purchasing programme all of which has so far failed to achieve the desired level of inflation (currently at 0.4%). It seems there is little that can be done over and above what is being done to encourage consumption over saving in Japan.