Pound Sterling: Signs of a Peak in Core Inflation Could Boost Fortunes against Euro and Dollar

• UK inflation stubbornly high
• But Core CPI looks to be topping out
• This could be supportive of GBP says analyst
• But falling global markets weigh for now

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The British Pound fell in the immediate aftermath of the release of UK inflation data which came in largely as expected, but some crucial elements of the report were softer and this could ultimately prove supportive of the currency.

UK CPI rose 9.1% year-on-year in May said the ONS, up slightly on April's 9.0% and in line with market expectations for 9.1%.

The month-on-month increase was 0.7%, which is more than the consensus was looking for at 0.6% but a sharp decline on the previous figure of 2.5%.

Above: "Annual CPIH inflation rate highest since April 1991 CPIH, OOH component and CPI 12-month inflation rates for the last 10 years, UK, May 2012 to May 2022. Source: Office for National Statistics."

But looking at core inflation - that kind which strips out external influences such as global fuel and commodity prices - and we see hints inflation might be peaking.

Core CPI grew 5.9% year-on-year in May, coming in below market expectations for 6% and below April's 6.2%.

The month-on-month core reading was at 0.5%, down on 0.7% previously and the consensus expectation for 0.7%.

The Pound's reaction to the data was mixed: on the release the Pound fell as the mechanical rule of thumb in foreign exchange is that lower than expected inflation lowers the need to hike interest rates by the central bank, in turn resulting in a softer currency.

A stronger than expected reading would have further cemented growing expectations for a 50bp rate hike at the Bank of England in August.

Paul Dales, Chief UK Economist at Capital Economics says the headline numbers won’t prevent the Bank of England from raising interest rates further, but crucially, "it may encourage it to opt again for a 25bps rate hike at its next meeting in August rather than upping the ante with a 50bps hike".

Above: GBP/EUR at hourly intervals taken in the wake of UK CPI inflation release.

For Sterling, "this week's attention will be Wednesday’s inflation figures forecasted at 9.1%, if this comes inline with expectations or higher, you can certainly expect the Pound to gain as a 50bps hike would certainly be on the table," says Matthew Rush, Corporate FX Dealer at Equals Money.

The fall in core inflation would have been picked up by traders as indicating the Bank of England might not need to accelerate rate hikes, therefore it is on balance a soft outcome for the Pound.

But the global economy is currently buckling under the strain of surging inflation: therefore if inflation is a negative for an economy, surely less inflation is good?

Given economic growth remains the ultimate determinant of a currency's value then any signs of easing UK inflation could be supportive of the growth outlook and the Pound.

"European FX are trading in line with stagflation," says Viraj Patel, Macro Strategist at Vanda Research, "so in-line/softer CPI is good for GBP".

The Pound to Euro exchange rate is currently at 1.1654, having opened the day at 1.1645, the Pound to Dollar exchange rate is at 1.2230 having started the day at 1.2264. (Set your FX rate alert here).

Arno Venter, Market Analyst at Financial Source, says the focus for Sterling isn't just on Bank of England policy right now, but but on where stagflation fears go.

"Lower CPI should counterintuitively be a positive input for GBP," he says, "won't sell GBP on lower CPI prints right now."

Above: GBP/USD at hourly intervals.

Note that global stock markets are sharply lower in midweek trade and this could ultimately be the key driver of FX markets over coming hours.

The Dollar tends to rise under such circumstances and the pro-cyclical and risk-sensitive Pound tends to struggle.

"Sterling has been a bellwether of risk appetite, which, given the small, open nature of the UK economy and the prominence of its financial sector, is understandable," says Thomas Flury, Strategist, at UBS.

Looking at the inflation data, the main culprit for surging inflation remains price rises for gas and electricity following the increase in the Ofgem cap on energy prices on 1 April 2022.

Energy falls under the bracket of housing and household services in the ONS' inflation breakdown:

Above: Contributions from housing and household services, and transport, account for more than half of the CPIH annual rate. Contributions to the CPIH 12-month inflation rate, UK, May 2020 to May 2022.

The latest gas and electric supply increase meant those on default tariffs paying by direct debit would see an increase of £693 from £1,277 to £1,971 per year.

The next Ofgem cap hike comes in October, when inflation is expected to peak with the Bank of England now forecasting a reading as high as 11%.

But Dales at Capital Economics says it is not obvious in this release that there are signs of the "more persistent inflationary pressures” that last week the Bank said would prompt it to "act forcefully".

He notes in particular the rise in services inflation from 4.7% to 4.9% does take it to its highest rate since 1993 and suggests that domestic price pressures are still strengthening.

"On its own, then, this release is probably not enough to seal the deal on a 50bps rate hike in August. Even so, we still think the Bank will raise rates from 1.25% now to 3.00% next year. That remains a higher forecast than the peak of 2.00% envisaged by a consensus of analysts," says Dales.