Prospect of Looming Bumper Inflation Prints Limits the Pound's Downside Potential

- GBP volatile around inflation release
- Inflation falls back to 2.0%
- "inflation dip represents the calm before the storm" - ING

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UK inflation came in below market expectations at 2.0% year-on-year in July, a miss that lead to some weakness in the British Pound although investors were quick to buy the dip with some economists saying a major uptick in inflation looms.

The market was expecting a reading of 2.3% while the July figure represents a marked cooling from June's 2.5% reading.

There was an initial knee-jerk move lower in the main Sterling exchange rates following the data, but that initial weakness has not been sustained:

Above: Initial sell-off in GBP on inflation stats was ultimately reversed.

The data comes at a time of subdued demand for Sterling against safe havens such as the Dollar, Euro, Yen and Franc, although gains are coming more readily against Emerging Market currencies and Asia-focussed currencies such as the New Zealand and Australian Dollars.

This dynamic confirms that a binary risk-on/risk-off dynamic is dominating Sterling and other major currencies at the current time, suggesting that any major movements in the Pound will more likely be linked with whether global investor sentiment improves.

"The generalised risk-off atmosphere in markets currently is not sterling’s friend and hence its inability to hold on to the highs that it hit last week," says Jeremy Thomson-Cook, Chief Economist at Equals Money.

The Pound-to-Euro exchange rate is quoted at 1.1730 at the time of writing, the Pound-to-Dollar exchange rate at 1.3740.

Above: Daily chart showing recent weakness in GBP/USD and GBP/EUR

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The outlook for the Pound therefore rests on a combination of both external market sentiment and domestic economic developments, particularly in regard to how they impact expectations for moves in Bank of England interest rates.

The Bank currently has its basic interest rates set at a record low 0.10%, but a strong economic recovery is expected to push up inflation over coming months, leading the market to believe a 2022 rate rise is likely.

The ONS said a large portion of the price rises witnessed in the UK in July were linked with the increase in cost of second-hand cars, a phenomenon seen elsewhere in the world and linked to a global shortage of chips that has stalled the market for new cars.

The experience of the U.S. has however shown this to be a temporary phenomenon and therefore those arguing that high inflation is a temporary phenomenon will be emboldened by this finding.

As such, there is nothing in today's data that suggests the Pound is a screaming buy, but as always it is what is coming down the track that matters.

How inflation develops from here will depend on other economic inputs, notably the labour market. Tuesday's labour report showed a sharp rise in wages and record vacancy levels suggesting limited slack in the economy.

UK wage growth hit a record of +8.8% Year-on-Year as companies posted more than 1 million new job vacancies in June for the first time, suggesting economic slack might be fast diminishing.

When the economy runs out of slack - or spare capacity - inflation can rise, putting pressure on the Bank to lift its interest rates to prevent an overheating in inflation.

This lift in interest rates is considered to be supportive of the British Pound as funds are sent to the UK by international investors to take advantage on the increasing returns higher rates offer.

The Bank of England said on August 05 they now expect inflation to peak at 4.0%, with their economists expecting inflation pressures to continue building over coming months.

If inflationary pressures do not build to deliver that 4.0% forecast then the market will see the prospect of a 2022 rate hike recede, easing the appreciation potential of the Pound in the process.

But 4.0% is certainly still possible say economists.

"With ongoing supply chain issues and higher energy prices set to add further upward impetus in the months ahead, inflationary pressures look likely to remain acute going into year end," says Hann-Ju Ho, Economist at Lloyds Bank Commercial Banking.

James Smith, Developed Markets Economist at ING says the "UK inflation dip represents the calm before the storm".

"UK inflation is unlikely to be far off 3% in August and will probably be fairly close to the Bank of England's 4% forecast by November," says Smith.

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Smith explains that much of the surprisingly sharp deceleration from 2.5% to 2% can be put down to things like clothing prices, and to a lesser extent, household goods.

But, he says the former had been seeing a sharp recovery in prices after recent lockdowns, while the latter had been pushed higher by global supply chain constraints.

Global supply-side inflation pressures are likely to rise, given reports of increased congestion in Chinese ports linked to Covid closures. This is in turn likely to maintain elevated commodity prices and disrupt supply chains.

"There’s little doubt that headline CPI will go well above 3% later this year – and in fact, the next set of data may confirm we got close in August," says Smith.

However, price pressures are tipped by ING to cool again in 2022 and Smith says for the Bank of England it is not so much the peak that matters, but how rapid the cool down proves to be.

"Ultimately, whether or not inflation stays higher for longer probably relies on wage growth accelerating," says Smith.

On this point, ING expects wages to ease over coming months as the UK exits the pandemic and the jobs market returns to normality.