BOE Backs Down From Easing Bias
Ahead of the November monetary policy meeting BOE governor Mark Carney noted that there are limits to the bank’s willingness to look through inflation. The sharp decline of Sterling over the last two months alongside an aggressive move higher in gilt yields seemed to unsettle the BOE who have since backed down from previous guidance that rates would be cut again this year.
The policy message in November, that the bank would be adopting a neutral bias going forward, alongside a slew of stronger than expected UK data readings has offered support the UK currency. Whilst the BOE is clearly going to remain vigilant, given the policy risks associated with Brexit, the Bank is highly unlikely to announce any further easing at this meeting and will instead reaffirm their neutral stance.
Brexit Developments Continue To Drive Price Action
Political developments concerning the UK’s Brexit negotiations continue to impact both investor sentiment regarding UK markets and the direction of Sterling. The sharp drop in Sterling since the June referendum has had a significant impact on UK inflation expectations. However, GBP has recovered well off the October lows on growing hope that the UK will now be able to avoid a hard Brexit scenario and retain Single market access.
Following a more than 6% decline over October, GBP found some support in November as the UK’s High Court ruling appeared to bolster hopes of avoiding a hard Brexit by ruling that parliament and not the government, hold the power to decide when Brexit can be triggered. Although the Supreme Court will not publish its decision on the PM’s appeal until at least early January, the government appears to have avoided the risk that the Court would go against it by achieving the support of a majority of MPs to commence Brexit talks by end March 2017 in line with the government’s original plan. Markets have also been encouraged by comments from Brexit Minister Davis that the UK would consider making a contribution for continued access to the EU’s Single Market.
UK Data Supportive Ahead of BOE
Economic releases out of the UK over the last month have continued to surprise to the upside maintaining the view that the “Leave” vote is yet to wreak any harmful economic impact. October Retail Sales were stronger than expected whilst October trade data showing a significant narrowing of the deficit. Furthermore, the November Composite PMI was shown to have moved to its best levels since the start of the year.
Money Market Reaction
A month ago, the combined effects of sterling weakness, backtracking by Carney on his prior intent to look through cost-push inflation and a better than expected GDP print has resulted in money markets looking for steady rates into 2018.
Inflation Outlook
Despite a softer print in October, UK November CPI rebounded firmly to print 1.2% over the month up from 0.9% the month prior and beating expectations of 1.1%, marking a new two-year high. A BOE survey has shown that consumer inflation expectations have increased by the largest amount in six years, reaching the highest level since 2014. Consumers expect inflation to average 2.8% over the next 12 months compared with forecasts of 2.2% in August. The survey showed that 41% of those surveyed now expect the BOE to raise rates by next November, up sharply from 21% in August.
The steep decline in Sterling combined with a surge in Oil prices is clearly fostering the view that UK inflation is on an increasing trend. At the November meeting, the BOE indicted that the move in sterling “had been sufficiently large to push projected inflation above the 2% target for an extended period”. In the bank’s central projections, contribution to CPI from prices of imports (excluding energy) and tradeable items was forecast to rise over 1%.
Rising Inflation Expectations
Despite firmer inflation expectations, wage growth has remained tempered. The growth in annual weekly earnings in the 3 months to September remained steady at 2.3% despite raised employment levels. Surveys indicate that UK job growth is forecast to slow in the near term whilst the weakness in UK productivity growth suggest that wage growth is likely to be capped.
As inflation eats into real earnings, growth and demand are both subject to downside risks going forward. This highlights why the BOE had previously been happy to look through cost-push inflation. If inflation expectations rise too far, however, second-round inflation effects could also bring undesirable consequences.
Whilst the BOE is likely to simply reaffirm its message of neutrality towards policy going forward, there are upside risks starting to creep into the picture as inflation continues to push higher.
Cable has turned higher once again this week and is set to make another push which will take price into its key challenge; a test of the broken post-Brexit lows around 1.28.