BoE inflation report: more from the ‘unreliable boyfriend’?

Mark Carney takes his latest turn in the spotlight this week as he unveils the Bank of England’s latest inflation report. On the same day, UK unemployment and wage data will be released, making it potentially the most important day for sterling since the governor’s Mansion House speech. 

Mark Carney
Source: Bloomberg

The inflation report is a semi-annual occurrence for Threadneedle Street – essentially it sets out the bank’s view of inflation in coming quarters, using the now infamous ‘fan charts’ that provide a variety of possibilities as to the predicted level of inflation. It is designed to give the bank as much wiggle-room as possible when highlighting the expected range of outcomes, but inevitably the consensus view will shine through.

When it comes to interest rates, Mr Carney will almost certainly stick to his ‘limited and gradual’ mantra that has become his standard response when pressed on the subject of UK interest rates. His delicate task involves sending the signal that the bank will not let inflation get out of hand, but nor will it raise rates too quickly or too steeply in a fashion that risks derailing the still-fragile economic recovery.

In addition, Mr Carney is likely to end up sending hints about the bank’s perception of the broader economy, including GDP growth and unemployment rates. The bank was caught out this year when unemployment dropped at a faster-than-expected pace, resulting in the 7% unemployment goal being dropped from the bank’s forward guidance policy. This time, the bank may cut its unemployment forecast once again, while at the same time reducing its short-term outlook for inflation. This would give it the necessary room on interest rates – weaker inflation reduces the risk that the UK economy is about to receive a sudden ‘price shock’, where the price of goods accelerates rapidly.

UK CPI growth still weak

The chart below shows the change in UK CPI since the early days of 2001. From this it is obvious that price growth continues to be weak, and that the recent turnaround does not change the general trend. This illustrates the bank’s problem nicely – CPI can rise rapidly, as was the case in 2009 and 2010, but it is hard to predict, and the BoE could very easily be left behind the curve.

Unemployment and wage growth

Before the inflation report, the latest data on unemployment and wage growth is published. The claimant count is forecast to fall by 30,000 in July, while the three-month unemployment rate is expected to drop to 6.4%. All this ties in nicely with the idea of a strengthening UK economy. However, the average quarterly growth in wages is expected to stagnate, declining by 0.1% year-on-year, from a previous figure of 0.3%.

As the graph below shows, this rate of wage growth would be the lowest level since 2010, below the weak period of 2012. Meanwhile, unemployment continues its steady decline towards pre-recession levels, as hiring picks up across the economy. 

Herein lies the BoE’s real problem – how to raise rates while working people are not seeing increases in their take-home pay. If it raises rates too early, it will create a major headache for consumers, as food prices and mortgages rise even as wages remain steady. If it hikes too late, inflation may have moved above its forecast and the bank will be forced into a series of sharp rises in interest rates in a bid to calm the situation.

Potential effect on cable

Analyst opinion on the timing of the first rate rise remains evenly divided along the November-February spectrum. November sees the next inflation report, and would be sufficiently far from the 2015 general election to steer the bank away from any political criticism. Recently, the post-Mansion House hawkish view of the currency has been reduced, and the pound has declined against the US dollar as a result. However, a more hawkish commentary on Wednesday would see some of that move lower erased, with GBP/USD perhaps pushing back in the direction of $1.70. 

The bank usually raises rates in 0.25% increments. However, it may opt for a symbolic 0.125% increase at some point this year, as a means of demonstrating its seriousness regarding the fight against inflation while underlining its ‘slow and gradual’ policy.

If wage growth is even weaker than forecast, or if the bank strikes a more dovish tone, then the pound could see a fresh wave of selling, pushing it further in the direction of the 200-day moving average around $1.6650; a move that would wipe out all gains made since April.

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