Mervyn King took the market by surprise this morning by indicating that the Bank of England could raise interest rates this year. So, after a session on the back foot yesterday, sterling has spiked aggressively against most of its major counterparts today, gaining a cent on the dollar and well over a cent on the euro.
Before today’s Quarterly Inflation Report, pessimism surrounding the UK economy was such that no interest rate rise was fully priced in by the market until January next year. Investors now seem confident that we will see some monetary tightening by the end of this year. Why? Not because of a more positive view of the UK economy, that’s for sure. Indeed, King expressed concern that first quarter growth was slower than expected and that the UK’s near-term outlook moving forward was downgraded.
The UK’s inflation expectations were upgraded, with the figure likely to hit 5% in coming months and to remain above the BoE’s official target of 2% for the whole of next year. We have already been warned that inflation could reach these levels, so why the huge response?
It was the somewhat hawkish tone of King that seemed to seal it. King has been distinctly dovish in the past, and it seemed like he meant business today, “Bank rate will rise at some point, it cannot stay at this level indefinitely.” He also stated that his May inflation forecasts were based on the assumption that interest rates will rise to 0.8% in the fourth quarter of 2011 and to 1% in the early part of 2012. So, a 25 basis point hike is now fully priced in for December.
Views surrounding BoE monetary tightening range from two rate rises this year (with the first in August) to none this year, and none next. Not to be fence-sitters, but we are somewhere in the middle. Today’s sterling positivity has been overdone in our opinion, we are more cautious about the UK’s struggling recovery.
Particularly in the absence of arch-hawk Andrew Sentance , the MPC seems likely to remain in wait for growth to come before raising rates. The picture will be clearer if last month’s slow in growth is shown to be temporary, as King indicates, or reflective of an even more fragile recovery than initially recognised. What’s more, the MPC has shown little concern with accusations that its weakening grip on inflationary pressures is calling its credibility into question. So despite King’s hawkish tones we'd prefer to wait for further evidence before bringing interest rate expectations forward.
Comments, as ever are welcome!
Richard Driver
Analyst – Caxton FX
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