GBP: Looking beyond CPI inflation – Rabobank

Jane Foley, Senior FX Strategist at Rabobank, explains that in a repeat of last month’s release UK July CPI inflation registered 2.6% y/y, below the market consensus of 2.7% y/y and unsurprisingly, the softer than expected headline rate has weighed on the pound on the assumption that it will wind back the BoE hawks. 

Key Quotes

“Despite the MPC being mandated to target CPI inflation, in reality the set of parameters that will govern the Bank’s next policy decision is far more complex.”

“The trajectory that is currently being drawn by UK CPI inflation is well understood.  The Bank have been stressing the point for some months that current prices pressures are almost universally a function of last year’s post Brexit referendum plunge in the pound.  Although the UK’s effective exchange rate has been fairly volatile in 2017, last year’s move in the exchange rate was a one-off event and its impact will drop out of the inflation index in the comings months.  There is already evidence that inflation pressures are easing in other UK indices.”

“The timing of the Bank’s next policy move may have less to do with whether CPI inflation prints a 2.6% or a 2.7% y/y figure over the next couple of months and more to do with investment data.  During his presentation of the Inflation Report earlier this month, Carney was keen to stress that as a consequence of political uncertainty, businesses were investing in the UK at a much less aggressive pace than otherwise would be the case given the favourable conditions implied by low interest rates and strong world growth.  Carney made the point that this suggests that on even a limited pickup in growth, capacity constraints could be reached which would likely have consequences for the Bank’s monetary policy decisions.   The Bank’s relatively hawkish warnings however, assume that capacity constraints will drive wages higher.  Indeed a recovery in wage growth is one of its central economic assumptions.  While it is logical to assume that falling unemployment levels will produce labour shortages and an upward boost to wages, there is currently plenty of evidence across the G10 to suggest that this mechanism is no longer straightforward.  In the UK, the ILO unemployment rate fell to a new cyclical low of 4.5% in May.  However, the latest reading of average weekly earnings registered a softer than expected increase of 1.7% 3m y/y.” 

“Any continuation of soft wage pressures going forward will make it difficult for the Bank to argue that capacity constraints are in danger of being hit.  Wage data are thus likely to be at least as important as the CPI release in gauging the timing of any BoE rate increase.  In our view the Bank are likely to stand pat on policy at least until the middle of next year and possibility longer if slow growth persists.  In view of the relative improvement in Eurozone fundamentals and the market’s perception that the ECB will wind back its QE policy in 2018 we are looking for EUR/GBP to maintain its uptrend.  We have revised our 12 mth forecast to 0.94 from a previous estimate of 0.92.  This is suggestive of a 12 mth forecast for cable at GBP/USD1.28.”