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BoE preview: will inflation force a hawkish tone?

With elevated inflation to deal with, Thursday’s BoE meeting brings about the potential for a hawkish tone from the MPC.

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Bank of England
Source: Bloomberg

Thursday sees the Bank of England (BoE) return to the fold, with the latest monetary policy decision expected to spark volatility for the pound and FTSE 100. Amid all the talk of a Brexit-fueled slowdown, there are many that believe we will not see a hawkish shift in policy for many years. However, the rising inflation rate is making that idea more and more conceivable. While we are highly unlikely to see any actual shift in the current quantitative easing (QE) or interest rates, the focus will instead be upon whether the BoE is moving closer or further away from a rate hike.

Economy

The UK economy has experienced a somewhat mixed period since the decision to leave the EU last year. To a large extent, the fact that the UK retained its own currency has helped immensely, with the pound forming an automatic stabiliser to any perceived negative effect it will have upon the economy. This has helped maintain a strong jobs market, with unemployment at a 40-year low. However, while the manufacturing sector seems to be benefitting from the weak pound, we are seeing less of an effect on the services and construction industries.

It is the impact which the weak pound has had upon inflation that will dominate monetary policy, and this meeting in particular. With the consumer price index (CPI) currently at 2.6% and core CPI at 2.4%, there is a clear fear that we could see a protracted and sizeable overshoot of the mandated 2% target. With inflation data due out on Tuesday, and jobs data on Wednesday, this week will provide some crucial information for the BoE to base their decision upon. Given the deterioration in UK average earnings growth, there is an argument to be had that a sharp rise in inflation could cause a more hawkish stance from the BoE in response to weakening real incomes.

Last month’s BoE meeting saw Mark Carney disclose that we should expect more than one interest rate hike over the next three years, but the first is unlikely to occur before the third quarter of 2018. While we are evidently some way away from a rate rise (or cut), any shift in tone will be key for markets, which would have to adjust to the newly perceived likeliness of a rate hike. With the pound having devalued even further against the euro since the last meeting, there is reason to believe we could see inflation rise once more. This will push the monetary policy committee (MPC) into a corner, which could result in a more hawkish statement come Thursday.

Ultimately, it is all about the credibility of those words, with the possibility of a rate-hike in the midst of a hugely testing Brexit process seeming somewhat implausible. To some extent, a hawkish BoE stance could be an attempt to spur the pound on to a period of strength, thus dragging inflation lower. One way or another, this meeting will tell us a lot about the BoE’s tolerance for the current levels of inflation, with the inflation figures earlier in the week providing a key clue as to whether the BoE is going to be under greater pressure to alter their stance.

Looking at the pound, we can see that it has turned a corner against the euro this month, with the trendline and simple moving average (SMA) break bringing a nice consistent downtrend. A rise in UK CPI tomorrow could bring another big move lower for the pair, leading to the belief that we could hear a more hawkish tone from the BoE on Thursday. 

EUR/GBP four hour chart

On the weekly chart, it is clear that there is a significant amount of room to the downside, given the sharp and unrelenting move higher in recent months. That could pave the way for a protracted period of downside for the pair, as indicated by the stochastic oscillator which has only just moved out of overbought territory.

EUR/GBP weekly chart

Ultimately, much of Thursday’s meeting will be reliant on tomorrow's CPI number. However, with BoE members increasingly voicing their concerns that the market is not fully pricing in the chance of a rate rise, it seems very plausible that we could see a hawkish tone from the committee. Whether that would actually reflect an increased chance of a rate rise, or simply a need to drive sterling higher and inflation lower, remains to be seen.

This information has been prepared by IG, a trading name of IG Markets Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients. See full non-independent research disclaimer and quarterly summary.

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