‘A risk worth paying’ Central banks could eye recession in bid to bust inflation

UK economy grows by 0.5 percent in new Bank of England data

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Soaring food prices helped push UK consumer price inflation (CPI) to a 40-year high of 9.1 percent in May, the highest rate among G7 countries. Sterling struggled for direction against the dollar on Friday, staying near more than two-year lows as nagging recession fears and political uncertainty weighed on sentiment.

The Bank of England (BoE) warned earlier this month the economic outlook for Britain and the world had darkened. It told banks to ramp up capital buffers to make sure they can weather the storm.

Hargreaves Lansdown senior investment and markets analyst Susannah Streeter explained that when faced with the expectation of an economy going into reverse, central banks in ordinary times cut interest rates and buy bonds.

She said because central banks have already done that, they can no longer use lowering rates as a lever.

Ms Streeter said: “They have little option but to put up rates. It’s really the only thing they can do. They see inflation as a bigger threat to financial stability.”

“If prices keep spiralling, that could create very difficult problems – making the cost-of-living even more expensive – which risk pushing the economy into a deep recession.

“By increasing rates now, it’s likely to hurt economic growth in the short term, but central banks possibly think that’s a risk worth paying to an even worse scenario emerging.”

The pound was up 0.08 percent to $1.18350 on Friday, but it was not far off Thursday’s low of $1.1761 – its lowest point since March 2020.

Sterling was largely flat against the euro at about 84.76 pence.

Major currencies have come under pressure this week as traders – increasingly fearful of recession – fled to the safe-haven dollar which is at a 20-year high.

On the pound’s direction of travel, Ms Streeter told the currency could weaken further against the dollar but may stay a bit stronger against the euro.

She said: “What will be worth watching closely is where inflation is going and signals in the US economy as to whether there will be a downturn.

“The dollar has the potential to be even stronger because the Bank of England will not be as aggressive in its rates hike.”

She warned the BoE could raise interest rates again if the next leader of the Conservative Party were to cut taxes, depending where they fall.

Almost all the candidates have said they would cut taxes if they are elected although former Chancellor Rishi Sunak has warned Tory rivals against unsustainable tax cuts.

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However, Ms Streeter said the leadership contest has not had as great an impact as other factors.

She said: “It’s not moved the dial that much. It’s adding to it, but it’s more in terms of what’s happening with the economy.

“The economy grew in May and ordinarily that would help the pound, and it did because there is an expectation the Bank of England will raise rates by 0.5 percent at its next meeting.

“But [May’s growth figure] was trumped by the inflation reading in the US, which means the US Fed will increase rates more than that.

“Against the euro, the pound is higher because of that better than expected reading of the economy. The Bank of England will feel there is more room to dampen down the economy because it now looks a bit more buoyant. The BoE wants to push down demand.

“Its likely that will lead to a downturn and even a recession, but the UK economy appears to be a bit more resilient than it looked just a few weeks back.”

That weakening demand is already evident with consumers moving away from purchasing big ticket items such as white goods and focusing on what they need rather than want.

A factor which could influence the euro’s fortunes in particular is closure of the Nord Stream 1 gas pipeline from Russia to Europe’s largest economy, Germany.

The pipeline is undergoing annual maintenance until July 21, but European governments worry Moscow could extend the date in order to restrict European gas supply thus disrupting plans to build up storage for winter.

Ms Streeter said: “There are energy security concerns about Russia. If they go away, that could see the euro lift a little bit.”

Supply chain disruption due to Covid and elevated oil prices also threaten to hamper global efforts to bring inflation down.

Ms Streeter said: “The Federal Reserve still says it’s set on raising interest rates. Until we get inflation dropping down to its target of two percent – although three or or four percent would be encouraging – it’s likely we will see this pattern continue for a while as there is such a long way to go.”

The Fed is expected to raise interest rates by 0.75 percent in August, triggering fears the US will tip into recession and nervousness on financial markets.

Despite this, the dollar is still seen as a safe haven compared to riskier currencies, including the pound and euro.

The euro is considered by some as particularly vulnerable because of the Russian energy shock.

Ms Streeter explained the market expects when it comes to raising rates the European Central Bank’s hands will also be tied and the BoE will be less aggressive than the Fed.

She said: “Usually, interest rates go up to cool the economy, but rather than cooling down a growing economy, it will be cooling down a shrinking economy. That’s why there’s a lot of volatility in the currency markets.”

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