Merlin Weekly Macro: It’s the economy, stupid

After analysing geopolitics for the past few editions, it is time to return to the hum-drum of economics.

Fed cuts and then dithers

This week, the US central bank cut the benchmark Fed Funds interest rate by a quarter point to a new target range of 3.75-4.0%. It suggested that rates will remain on hold for the time being.

The Federal Reserve has a dual mandate for monetary policy. The first is running the economy to an average inflation rate of 2% (specifically measured by Core PCE inflation, which excludes what are regarded as volatile food and fuel prices, even though in the real world Americans must eat and keep warm and incur travel costs all of which are an integral part of their housekeeping budgets). Second is promoting maximum employment, which in its practical application means finding the optimal level of economic activity that keeps as many Americans in work as possible but without itself creating inflation.

Sometimes, the mandates conflict. The US headline inflation rate as measured by CPI increased from 2.3% in April to 3.0% at the end of September; core inflation accelerated from 2.8% in the Spring, peaking at 3.1% in August before paring back to 3.0% in September. Meanwhile, US unemployment has been drifting up from 4.0% last December to 4.3% now. An inflation rate 50% greater than the official target would suggest that the Fed should not be loosening policy and stoking the economy without running the risk of creating further upward pressure on prices. Pulling in the opposite direction, a slowing labour market as evidenced not only by a gradually rising unemployment rate but by supporting data pointing to deteriorating rates of lay-offs and hirings, all indicate a weakening economic outlook in need of monetary relaxation and lower interest rates.

Governor Miran features large

It is not surprising that the Fed’s monetary policy committee was split about what to do. Clearly the majority was in favour of supporting the jobs market as a greater priority than being concerned about inflation and were supportive of that helping-hand quarter point cut which was announced. However, arguing for a more hawkish approach, Kansas City Fed President Schmid was in favour of leaving rates on hold. Taking a distinctly dovish stance, newly appointed Board Governor Stephen Miran argued for a half point cut. Regular readers will remember Miran: he is Trump’s personal economic adviser, author a year ago of a 40-page paper published by Hudson Bay Capital entitled, “A User’s Guide to Restructuring the Global Trading System”. Chapter 2, “Theoretical Underpinnings: The Roots of Discontent Lie in the Dollar”, argues that the US dollar is overvalued. It makes imports too cheap and US exports uncompetitive. Miran was essentially the author of Trump’s tariff strategy which, in his own idiosyncratic way, Trump has followed to the letter. Arguing for an aggressive half point cut to help reduce the value of the dollar, Miran’s view is entirely consistent with his strategy to redress the US balance of payments but pays zero heed to the Policy Committee’s mandates.

Trump has Miran in mind to take over the chairmanship of the Federal Reserve when incumbent Jerome Powell retires in May 2026 (Powell’s term as a governor expires in January 2028, if he stays that long). The role of chair is to facilitate robust debate about future policy and to steer the committee to a consensus or at least a majority decision; the chair may have his/her own robust views but theirs is not the role of a dictator. Trump wants a lower dollar; Miran argues the academic-economic angle of why it is desirable. But as Chair of the Fed, it would not be in Miran’s gift to deliver it through lower interest rates. Depending on that key appointment, sparks may yet fly behind closed committee doors, and tensions with the White House may persist. It is a fascinating but unsettling prospect.

Two very different perspectives on US inflation

However, for the person in the street, the difference between those two measures of core and headline inflation is semantic and irrelevant. Much more pertinent to the day-to-day purchasing power of their dollar earnings and maintenance of living standards is the extent to which the American Joe Public feels the pinch in their wallets, purses and domestic financial circumstances.

There is a very unofficial measure of US inflation. The Chapwood Index is sampled annually across the 50 biggest cities, it “reports the actual price increase of the 150 items on which most Americans spend their after-tax money. No gimmicks, no alterations, no seasonal adjustments; just real prices.” For 2024, the official national data recorded a core inflation rate of 3.2% and headline inflation of 2.9%; the Chapwood Index populist rate of inflation averaged 11.1% across those 50 key population centres for 2024. Academics poo-poo such surveys, maintaining that the methodology is riddled with flaws. They miss the point. Whether the numbers are accurate or not is unimportant: when it comes to household costs and standards of living, perception and reality are synonymous. But consider the policy perspectives and ramifications: as far as the Fed was concerned last year, average real interest rates adjusted for inflation were positive to the tune of 1.9%, while for American households they were negative at a rate of minus 5.8%; likewise, the annual cost-of-living increase of 11.1% far outstripped the official rise in US average wages of 1%. The political repercussions are obvious: if it’s “all about the economy, stupid”, opinion will tend to favour politicians who level with the electorate and who then do something to put it right; electorates tend not to like being taken for a ride.

Rachel Reeves: about to break a big manifesto promise?

For which Rachel Reeves in the UK should take heed. Now with less than a month to go before the Budget, speculation mounts about what she will do to plug the latest “black hole” (i.e. unplanned shortfall) estimated at anywhere between £20 billion and £50 billion (as this time last year when she was preparing her first outing of “Securonomics”, it’s a case of pick a number, any number will do). On offer this week is 2p on income tax, partially offset by a reduction in employees’ National Insurance (ostensibly leaving it neutral for net earned income for “workers” but capturing a greater take on unearned income including from pensions, investments, rents etc); also heavily trailed, a “mansion tax” levied at 1% on the value in excess of a £2m hurdle on domestic properties including primary residences; and revisiting a perennial target, reducing tax-free lump sums on pension pots (to which add the habitual sleight of hand of all governments attempting to seize money surreptitiously, the freezing of income tax bands and the resulting fiscal drag of a greater number of people drawn into a higher tax bracket).

Commentary abounds as to the art of the possible, and how this-and-that economic data about to be published will be “critical” to her calculations about how much the Chancellor needs to find. But all that is to miss a fundamental point. Even if Reeves keeps the bond markets sweet through staying within her fiscal rules, there is an intellectual deception being perpetrated on the electorate: that the aim is growth which requires investment from higher taxes to achieve it. The Office for Budget Responsibility’s own projections undermine the argument: growth and productivity forecasts are being downgraded but much more importantly the Treasury is fighting a losing battle with the spending departments and Labour backbenchers about the ability to contain public spending. The political crisis in May, when Starmer capitulated over the required £5 billion of cost savings in the welfare budget, was not about reducing the relevant health and disability welfare spending from £47 billion where it is today to £42 billion; it was about trying to shave £5 billion off the £77 billion that the same budget is projected to be in 2029. Taxes are not rising to invest in growth; to be clear, they are rising to stem a financial haemorrhage, to which the government’s own borrowing costs are a significant contributor, and to prevent a bond market melt-down. From an economic and fiscal policy perspective, there is little that capitalist fund managers such as us can find as common ground with the political agenda of the Green Party. Indeed, most of their views on the redistribution of wealth and their rejection of GDP and economic growth as barometers of the progress of society are ones we fundamentally disagree with. But there is no argument about where they are coming from. It might be wrong-headed (in our view) but at least it is utterly honest.

Labour on the other hand arrived with a manifesto full of promises, platitudes and worthiness for a fairer society, but in which national wealth creation and growth also featured large. But critically, it had no thought-through economic plan. “Securonomics” was a paper concept much more than it was a rigorous, implementable roadmap. That it has consistently been found wanting is thanks to a lack of preparation, vision, a grip on the subject, and leadership.

There is an old saying in politics: “you can fool all of the people some of the time; you can fool some of the people all of the time; but you can’t fool all the people all of the time”.

Rachel Reeves is about to find the reality of that the hard way, particularly if she reneges on the explicit manifesto commitment not to raise the rate of income tax, and the equally explicit denials she gave ahead of the election that a Labour central government would not directly tax the value of homes. Hers and the Cabinet’s is a cynical calculation that few will be impacted and most of those who are affected are not Labour supporters anyway.

The reality is that such policies will leave everyone less well-off.

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