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Inflation picture puts pressure on BoE

While no change in policy is expected at tomorrow’s BoE meeting, recent strength in inflation readings may force the Bank into a hawkish turn. 

Having finally raised interest rates at its last meeting, for the first time in ten years, this Bank of England (BoE) meeting is not expected to be half as exciting. Since the last meeting, there have been some broader developments that may merit a mention. The most obvious of these to be mentioned at this meeting is the Brexit deal between London and the EU, which has, it seems, set the UK’s exit fee as around £39 billion, with the two sides now moving forward to discuss trade. This does not entirely dispel the uncertainty surrounding Brexit, but it does at least signal that progress can be made. While the pound fell against the dollar following the news, it had already rallied sharply into the announcement, so a degree of ‘buy the rumour, sell the fact’ was to be expected.

The other key change is the recent rise in inflation. Tuesday’s consumer price index (CPI) figure rose to 3.1% year-on-year, the fastest rise in six years. This comes after the prices paid component of the monthly services purchasing managers index (PMI), which measures activity in the vital services sector, hit its highest level since February 2008. The CPI figure is more than a percentage point above the Bank’s 2% target; sterling weakness since the election continues to be the cause, even if GBP/USD is off the lows of last year.

The BoE thinks price increases will slow from December onwards, but the services PMI prices figure suggests that the rise in price growth is not as transitory as some think. Consumer spending is under pressure, as wage growth fails to keep pace with the rise in prices. Average weekly earnings growth has been negative since March 2017, with little change in sight. This is not good news for a UK economy built largely on consumer spending and services industries.

The general perception from the last meeting was that the Monetary Policy Committee (MPC) was in no hurry to keep raising rates. However, with inflation stubbornly above target, a judicious bit of hawkish commentary may be necessary, in order to try and boost sterling and reduce the impact of imported inflation. Current market expectations are for another 25 basis point increases by the end of 2020, which would take the interest rate to 1% from its current 0.5%. Even then, this is still remarkably loose monetary policy by the standards of the pre-crisis years.

A more hawkish MPC may give sterling a lift. As a result, we are watching GBP/USD to see if the pair can maintain its upward progress from the 2017 low at $1.20. Since then, we have seen a steady progression of higher lows, reinforcing the impression that the market thinks sterling should trade higher. A close below $1.32 would call this uptrend into question, but it would take a move below $1.3050 to really suggest a downward move is gathering strength. Otherwise, further bounces will target $1.3550 and then $1.3659.

The other pair to watch will be EUR/GBP. Since June, the £0.8733 level has been staunchly defended, but rallies since September have stalled at £0.9033. Above the latter, the £0.9306 level comes into play, while if £0.8733 is broken the next big support areas are down at £0.8402, and then £0.8304.

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