The following article was written by Ipek Ozkardeskaya, Senior Market Analyst at FCA regulated broker London Capital Group Holdings plc (LON:LCG).
The Bank of England (BoE) will meet on Thursday and is expected to keep the bank rate unchanged at the historical low level of 0.25%, maintain its sovereign bond purchases target at 435 billion pounds and the corporate bond purchases target at 10 billion pounds.
The accompanying statement is expected to remain comfortably dovish. BoE Governor Mark Carney has repeatedly stressed out the bank’s tolerance for a higher-than-usual inflation rate due to the ‘Brexit reality’. However, the rising inflationary pressures may leave many Monetary Policy Committee (MPC) members scratching their heads.
According to the latest inflation data, the British consumer prices rebounded to 2.9% year-on-year in August, from 2.6% printed a month earlier and beating the analysts’ forecast of 2.8%. The core inflation surged to 2.7% year-on-year from 2.4%. The stagnation in wages didn’t translate into a lower inflation so far.
If the inflation rises above the 3% level, Mark Carney will have to write an open letter to the Chancellor explaining the reasons behind the significant deviation from the 2% mandate target.
The depreciation in the British pound posterior to the Brexit referendum is a major explanatory factor regarding the spike in British consumer prices.
Despite the recent bounce in the pound against the most-watched US dollar, the trade weighted data suggests that the pound is still at a decade low levels since July 2016 and this weakness is causing a severe imbalance between the inflation and wages.
In fact, the gap between the price and wages inflation widens as the inflation trends exponentially higher while the wages growth is relatively stagnant. Earlier this year, Mark Carney assumed that the deterioration in British households’ purchasing power would temper the rising price pressures. It must be noted that things did not evolve in the way he expected. The UK’s several sector workers protested their lower living standards, but the actual impact on the inflation was rather insignificant.
In fact, the BoE has its hands tied at the moment. In one hand, the cheaper pound causes a significant rise in imported products’ prices and tighter monetary policy could support the pound’s value and temper the imported inflation. But on the other hand, higher interest rates would tighten the monetary conditions across the sectors, pushing the borrowing costs higher for businesses, which in turn could cause job losses and stagnant salaries.
Although the BoE is not expected to raise interest rates any time before next year, the split at the heart of the MPC is crucial for the pound’s immediate valuation in the currency markets.
According to recent analyst surveys, at least two MPC members could vote in favour a rate hike at Thursday’s meeting.
Pound rises on hawkish speculations
The pound rose to a year high as a reaction to the August inflation data. The GBP-bulls are expected to dominate ahead of Thursday’s BoE meeting. The next important technical level is 1.3420. The pound will have pared half of the post-Brexit losses against the greenback at this level.
A dovish surprise could encourage a downside correction. The key support to the mid-August – September rise stands at 1.3108 (major 38.2% retracement), if broken could pave the way for a further slide to 1.3044 (Fibonacci 50% level) and the 1.30 mark.
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