UK Headline inflation hits 4.4%: Where does the MPC draw the line?

This morning’s data revealed that UK inflation rose to 4.4% in February, a jump of 0.4% on the month, to the highest level since November 2008. In exceeding expectations, the increase in inflation has renewed the possibility of the BoE shifting interest rates, which has helped lift sterling but the market response has still been cautious.

Why? Mervyn King has already warned that inflation will rise towards 5.0% this year, which has taken the edge of an otherwise shocking increase. The figure also failed to realise rumours circulating of an even larger. Perhaps more importantly though, the data is just one of a series of important UK announcements this week, including the MPC’s minutes and UK monthly retail figures. Investors are likely to want a clearer picture of Britain’s economic conditions before taking up positions.

King has set his stall out in past announcements: he has recognised inflation is alarmingly high but asserts that it’s down to temporary factors which will begin to subside within a year. Moreover, King maintains that the dangers posed by a premature rate cut (which could risk pushing the UK back into recession), outweigh those posed by the current levels of inflation.

The market has fully priced in an August BoE rate rise but some are now leaning to a rate rise as early as May. We find this hard to believe even in light of today’s data, though if tomorrow’s minutes reveal an unlikely hawkish recruitment within the MPC, this argument will be far stronger. A rate rise in June remains our view. The pressure really is mounting on the MPC to slow down inflation - they are at risk of losing their credibility - particularly as the ECB are almost certain to embarrass the BoE by raising rates in a fortnight (inflation in the eurozone is only running at 2.4%!).

Following today’s data, sterling is currently trading at a fourteen month high against the dollar (near $1.64), though this has more to do with dollar weakness than with sterling-positive news. Despite a good day, the pound is still struggling against the euro at lows around €1.15. Looking forward, the risks for sterling are actually skewed somewhat to the downside; tomorrow’s UK budget release is unlikely to inspire the markets and the euro may make some more ECB rate hike-related gains - though these may be limited now that such a move has been largely priced in. Investors may also use sterling’s recent gains as an opportunity to take some profit.

What the pound needs is for Thursday’s UK retail sales data to be positive in order to reignite some confidence in the UK’s recovery, which in turn may convince a couple more MPC members that our economy can withstand monetary tightening. However, this seems somewhat unlikely given the forecasted 0.4% monthly contraction.

Richard Driver
Analyst – Caxton FX


For the latest forex news and views, follow us on twitter @caxtonfx and sign up to our daily report.

What next for Sterling?

The MPC meetings minutes were released this morning much, I’m sure, to the embarrassment of policy member Martin Weale who decided to dance to the tune of raising interest rates. He now joins Andrew Sentance – who has been voting for this policy shift for the past 4 months  – and will probably be rethinking his decision after the release of Britain’s shock GDP figure.

Mervyn King meanwhile, smug in the knowledge that he refused to bow to inflationary pressures, used a speech yesterday to defend the Central Banks ultra lose monetary policy in the face of high inflation. He reiterated that the economic recovery would be ‘choppy’ (understatement if ever I saw one), and that real wages would be heading lower. I’d imagine that King’s Speech will not have been received quite as well by the public as its multi Oscar nominated names sake.

The question now is; what will become of the pound if these figures are to be relied on? How much of a toll did the weather take on these preliminary results? After all, the economic impact of the snow is extremely hard to quantify. My feeling is that the figure of -0.5% shouldn’t be taken at face value. Certainly the recovery has been blown off course, but we should wait for the second and final estimates before completely reassessing the situation. The figure is at odds with the PMI (Purchasing Managers’ Index) surveys and the National Statistics Office has been wrong before, notably coming in 0.4% wide of the mark in the final quarter of 2009. A similar revision this time around could well be on the cards.

Nonetheless, the pound must still deal with the dual hangover of weak economic growth and high inflation: ie stagflation. This is not a concept that will rest too comfortably for the pound. Whereas the expectation of higher interest rates gave sterling a boost in the early part of the year, that eventuality has lost all credibility. Indeed, the prospect of such a move from the Bank of England looks about as likely as Andy Gray presenting Woman’s Hour.

With key US announcements due today and Friday, the market should avert its attention from the UK economy at least in the short term. However, any lasting relief for sterling will depend on a fresh wave of eurozone concerns or these lowly €1.15 levels could endure for now.

Edward Knox

Analyst

For the latest forex news and views, follus on twitter @caxtonfx.com and sign up to our daily report.