What Do They Know That We Don't?

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

It was announced earlier today that the Bank of England (BofE) has raised its key rate by 50 bps representing the largest increase since 1995. This marks the sixth consecutive meeting in which they've raised this rate, which now stands at 1.75%. This decision follows England's June inflation reading of 9.4% (the US is at 9.1%). The aggressive pace of rate increases mirrors the U.S. Federal Reserve's, but the magnitude has been slightly less intense, as the Fed Funds Rate currently sits at 2.25% to 2.50%.

In announcing this latest increase they also provided perspective on the future paths for both rates and inflation in stark contrast to the recent pronouncement by the U.S. Federal Reserve which stated that future "guidance" would be limited. BofE is anticipating inflation to eventually peak at 13.2% during Q4'22. They are also forecasting that Great Britain's economy could suffer a recession for 5 consecutive quarters beginning later this year. However, that is not going to impact BofE's decision to aggressively fight inflation, which mirrors the US Fed's position that inflation poses a great threat and must be tamed even if economic growth is impacted in the short term.

It is fascinating to watch the market activity within the U.S. at this time, as investors seem sold on the idea that inflation has already been tamed and that rates will have to fall in the near term. The U.S. has not posted an inflation # yet that would indicate that inflation has peaked. Furthermore, the Fed Funds Rate is at 2.25%-2.50% which is at the low end of the normal range of 2% to 5%. In 1975, the Fed increased the FFR to 13% in July while inflation was still at 11.5%. The US economy would fall into recession later that year and the Fed aggressively reduced rates once again to 5.25% by April, but inflation remained elevated at >10%. This premature action would lead to the Fed eventually raising the FFR to 20% in March 1981. It wasn't until 1982 that inflation eventually fell below 10%, but rates remained elevated with the FFR still at 20% in March 1982.

Given the history cited above, just how much economic activity will they have hampered with rates remaining this low? Remember, inflation peaked in early 1980, but interest rates didn't begin to fall until 1982. If a similar pattern forms, bond "investors" will be sitting on huge negative real returns for quite some time. That is not a winning strategy!