Blow for British Pound as Inflation Grinds Lower

March has been a poor month for the pound sterling with the strong rally against the euro and other majors coming to a halt.

The correction lower must be expected, simply on the basis that financial assets never move in a straight line.

However, the latest inflation data from the ONS suggests to us, and the market reaction confirms this, that the correction could well turn into something a little deeper.

The year-on-year inflation rate fell to 0%, analysts had expected inflationary pressures to remain in positive territory at 0.1%.

According to Jacqui Douglas at TD Securities, inflation should fall further before rallying towards year-end:

“It had previously looked like a close call on whether UK inflation would quite make it into negative territory or not, but it now looks like it should hit something negative next month with the March data, then turn marginally positive in Q3 before squeaking back up to 1.0% with the Dec data.”

Inflation falling at a faster-than-expected rate is clearly welcome news for UK consumers, and businesses, that have endured a torrid decade of economic uncertainty.

However, for those watching the currency markets and hoping on a stronger pound sterling, the data is without doubt unwelcome news.

Differences in interest rate yields between different countries remains the undisputed key driver of exchange rate levels, as this graphic explains.

What low inflation means is that the Bank of England can now afford to keep pro-GBP interest rate rises on the back-burner, for longer.

“This clearly isn’t an environment that warrants a rate hike and unless wage growth picks up sharply from its currently rate of 1.8%, the few hawks on the MPC are going to have a very difficult job in convincing the majority that a rate hike is necessary this year,” says Andy Scott at HiFX.

Having hit 1.4250 two weeks previous, its highest level in over seven years, the pound euro exchange rate (GBPEUR) has since dropped back by 4.5% to 1.3600 today.

Losses against the commodity dollars (New Zealand, Canada and Australia) are also gathering pace.

The dollar meanwhile maintains its dominance over sterling in line with the broader-based USD bull trend.

Nevertheless, the longer-term outlook for GBP remains positive says Dennis de Jong from UFX:

“Regardless of there being only a very slim chance of a U.K. rate hike this year, we expect sterling to remain strong against the euro and to recover against the dollar in the months ahead.”

Reactions to Inflation Data

De Jong confirms that the low inflationary environment will have a positive impact on the UK economy and its government:

“George Osborne’s reputation is at an all-time high after delivering what many considered a strong Budget last week.

“That combined with positive economic readings across the board has buoyed the Conservatives ahead of May’s general election, and the chancellor will be out to put a positive spin on inflation being at its lowest since records began.

“In the short-term it is good news for consumers, but any planned interest rate rises are off the cards now. And, while prolonged deflation seems improbable, it is unlikely that wages increases will continue to rise at above inflation levels.”

Commenting on figures released this morning which showed inflation (CPI) running at 0.0% in February 2015, James Sproule, chief economist of the Institute of Directors said:

 “We welcome the news that inflation has once again fallen. It is particularly encouraging that this has been driven by falling fuel costs. This is putting extra spending power directly into people’s pockets and is acting as a further catalyst to economic growth.

“Looking to the longer-term, we are encouraged that IoD members are planning pay rises for their staff in 2015. In the majority of cases these will be tied to improved corporate performance. This is the sort of responsible decision which will ensure economic growth is sustainable.

“However, low inflation does mean that governments must be that much more careful with decisions on tax and spending, as very low, or zero, inflation means miscalculations cannot be eroded in future years by inflation. An incoming government must be very aware that they will have to live with any changes to tax rates or thresholds for the long term.”