Sterling Retreats on Surprise Slowdown in Inflation, but this is Good News Longer Term as the Squeeze on Consumers Ends

Image © Andrey Armyagov, Adobe Stock

- Inflation numbers dent Sterling's advance

- But, falling inflation and rising wages = good news for consumers

- Any impact on Sterling likely to be limited as Brexit is main driver

The British Pound was seen moving lower on the back of some disappointing inflation numbers for September that showed both headline and core inflation came in below expectation.

The Office for National Statistics reports that headline inflation read at 2.4% year-on-year, down on the previous month's 2.7% and below consensus forecasts for a reading of 2.6%.

Pound Sterling was seen moving lower on the back of some disappointing inflation numbers for September that showed both headline and core inflation came in below expectati

The fall was driven by lower food price inflation and a reversal of the increase in computer games and theatre ticket inflation seen in August. Inflation in the transport category also eased slightly.

Core CPI read at 1.9% on an annualised basis, down on the previous month's 2.1% and below consensus forecasts for 2.0%.

The core CPI number is arguably more important as this is the kind of inflation that is generated by domestic price pressures, and is therefore more likely to influence the decision making process at the Bank of England.

"September's sharp, broad-based fall in CPI inflation eases the pressure on the MPC to push through another pre-Brexit rate hike. Still looks like CPI inflation is heading BELOW the 2% target next year, given that domestically-generated inflation is low and rising only gradually," says Samuel Tombs at Pantheon Macroeconomics.

The Bank of England tends to raise interest rates when inflation is rising as it acts as a dampener on price increases; a side effect of rising interest rates is a stronger Pound. 

Therefore, today's data suggests the Bank of England can afford to sit back as inflation is not yet a headache, hence Sterling's retreat. 

At the time of writing, the Pound-to-Euro exchange rate is quoted at 1.1379 having been as high as 1.1404 earlier in the day, the Pound-to-Dollar exchange rate at 1.3161, having been as high as 1.3192 earlier in the day.

Despite the inflation numbers being disappointing for the Pound, they are no doubt good news for U.K. consumers who are now in an enviable position where price pressures are fading while wages are increasing.

"The easing off in inflation is good news for consumers. Indeed, with headline annual total pay growth ticking up to 2.7% in August, the fall back in inflation in September suggests that real wage growth has picked up further," says Andrew Wishart, UK Economist with Capital Economics.

Yesterday the ONS reported U.K. wage increases had hit their highest levels in ten years as he economy is now seen close to full employment.

The Pound rallied in response with markets betting that the data gives reason for the Bank of England to increase the pace at which they raise interest rates going forward. However, today's inflation data more-or-less cancels out these positive expectations.

"With inflation in line with the Bank of England’s forecast, and measures of domestically generated cost pressures, such as core inflation and services inflation falling back, this reduces any pressure on the MPC to act again before it can assess the likely impact of the Brexit negotiations," says Wishart.

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Impact on the Pound's Outlook

The initial knee-jerk reaction by Sterling to softer inflation data is to fall; this is text book stuff.

However, it is hard to argue that this is a materially negative development for Sterling, particularly longer-term. Indeed, that Brits are now seeing more Pounds in their pockets at the end of the month can only be a good thing and bodes for a more robust economic framework going forward.

"The squeeze is over," says Kallum Pickering, Senior Economist with Berenberg Bank, "real wages are rebounding strongly from the sterling related squeeze following the June 2016 Brexit vote."

And Pickering believes the outlook for post-Brexit Britain is constructive:

"Real wage growth should improve over the medium term as inflation gradually trends towards to BoE’s 2% target and tight labour markets push nominal weekly earnings growth higher. Real weekly earnings growth can rise towards 1.0% by early-2019."

This outlook is provisional on an orderly Brexit deal can be done, which Berenberg see at being 80%.

Near-Term, Brexit in Control

We would expect any material impact on the British Pound from these numbers to be relatively short-lived as Brexit remains front and centre for Sterling and there should be no shortage of Brexit intrigue today with the start of the European Council meeting in Brussels.

U.K. Prime Minister Theresa May travels to Brussels to brief fellow leaders at a pre-summit dinner. More specifically, May is the pre-dinner entertainment act, as she will address them on Brexit and then be turfed out to go and find a meal elsewhere.

Don't expect a breakthrough, but we think the tone of European leaders over coming hours and days could be instrumental in moving Sterling. As we note here, markets appear to be viewing the current deadlock as political shenanigans, with both sides acting tough ahead of a final deal; hence why the British Pound appears rather well supported despite the dire political headlines.

Also keep an eye on Bank of England Monetary Policy Member Ben Broadbent who is due do deliver a speech at 18:00 B.S.T.

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Lock in Sterling's current levels ahead of potential declines: Get up to 5% more foreign exchange for international payments by using a specialist provider to get closer to the real market rate and avoid the gaping spreads charged by your bank when providing currency. Learn more here