Pound recovery to $1.30 could temper inflationary pressures in the UK

UK inflation pound sterling

This article was written by Ipek Ozkardeskaya, Senior Market Analyst at FCA regulated broker London Capital Group Holdings plc (LON:LCG).

Ipek Ozkardeskaya, LCG

The inflation and employment data were the key highlights of the week in the United Kingdom.

Inflation neared the BoE’s 2% target

The headline inflation decelerated by 0.5% month-on-month in January, while the yearly inflation advanced to 1.8% versus 1.9% forecasted by analysts. The core inflation accelerated to 1.7% year-on-year from 1.6%.

The cheap Sterling and the rise in oil and energy prices were the major drivers of the inflation in January. Output prices rose by 3.5% year-on-year, up from 2.7% printed a month earlier. Producer prices excluding food and energy advanced by 2.4%y/y, compared to 2.1% in December.

Labour market could be approaching full employment

On the labour side, the unemployment rate remained steady at 4.8% as expected, while the wages grew 2.6% year-on-year, slightly less than 2.7% a month earlier.

The slowdown in wages growth somehow confirmed the Bank of England (BoE) Governor Mark Carney’s feel that the UK’s labour market is nearing the full employment, meaning that Britons would offer their labour at the current level of income.  Onwards, tighter jobs market would have a marginally decreasing positive pressure on salaries, hence on the future inflation.

The BoE could soon be left behind the curve

Given that the bank’s inflation target is almost reached and that the labour market is nearly pointing at the full employment, in theory, the Bank of England would be at a position to slowly normalize its monetary policy by raising the interest rates and eventually taper its asset purchases.

Yet the Bank of England’s hands are firmly tied together due to the Brexit. For the next two years at least, the BoE is planning to hold an accommodative monetary policy to support the economy through the critical EU exiting process, to temper any unsolicited economic shock and to avoid an eventual slowdown in the economic activity.

In this perspective, Mark Carney had clearly stated that the bank would tolerate a higher inflation, above its 2% mandate target.

The problem is, if Mark Carney’s full employment theory fails and if the inflationary pressures on wages and consumer prices rise excessively fast, the Bank of England would be brought to deviate from its original plans and to tighten it policy prematurely to halt an eventual overheating at the heart of the economy.

The inflation in the UK is expected to cross above the 2% level in the first quarter of 2017.

Exceeding a 3% inflation print, Governor Carney will be required to send an open letter to the Chancellor to justify why the bank has moved ‘significantly’ away from its mandate target.

What does this mean for the pound?

Rising inflation hints at mounting speculations for a tighter monetary policy. Although for the time being, investors give slightly over 20% probability for a rate action by December 2017, the odds are fifty-fifty by mid-2018. This is sensibly earlier than the BoE’s two-year horizon for accommodative policy.

Though not alarming, the market is building a slightly hawkish bias, which suggests that the pound at the current cheap levels, may not be sustainable for an extended period of time.

After having tanked by more than 20% following the Brexit referendum, the pound should to stabilize and perhaps gather further strength in order to achieve a new equilibrium.

In the medium term, Cable should strengthen to 1.3000 in order to keep the inflationary pressures at a level appropriate for a BoE status quo.

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