British Pound Sinks Deeper into the Red as Lower Inflation Muddies Bank of England Outlook

-GBP falls deeper into the red after UK inflation stabilises in May. 

-Headline CPI holds at 2.4% and core CPI stalls a 2.1% in May.

-Confirms 2018 fall in inflation more than just temporary weakness.

© IRStone, Adobe Stock

The Pound fell broadly Wednesday after Office for National Statistics data showed the consumer price index stabilising at a year-long low during May, despite a sharp rise oil and energy prices this year, which has further muddied the outlook for Bank of England monetary policy.

The consumer price index came in at 2.4% for the month of May, which is the joint lowerst level for the index since March 2017 but in line with market expectations.

Core consumer prices, which remove volatile food and energy items so are seen as a more accurate representation of domestically generated inflation pressure, held steady at 2.1% for the recent months.

A steep increase in motor fuels prices provided the largest upward contribution to inflation during the month, according to the ONS, but downward movements in prices of games, domestic electricity, food and alcoholic beverages offset all of the upward pressure from on the index from rising fuel costs.

Both numbers are still above the 2% target of the Bank of England although they also add weight to claims that the 2018 fall in inflation is here to stay, rather than being just a temporary phenomenon. The consumer price index has fallen from 3% in March, while the core consumer price index dropped from 2.7% over the same period.

"As we had expected, the rise in fuel prices – which posted the biggest monthly increase since January 2011 – offset the downward pressure from one or two of the core sectors, such as recreational goods and household services," says Ruth Gregory, a UK economist at Capital Economics. "With few signs of “second-round” effects on wage claims and inflation expectations, we still expect CPI inflation to drift down later this year, as the inflationary impact of sterling’s fall continues to wane." 

Markets care about inflation because it has implications for interest rates, which are themselves the predominant driver of exchange rates because of the influence that rising and falling returns can have on international capital and speculative money. It is inflation that central banks are attempting to manipulate when they tinker with interest rates.

"CPI inflation should resume its downward trend in Q3 as food and core goods inflation continue to normalise, having been boosted by sterling’s depreciation over the last year," says Samuel Tombs, chief UK economist at Pantheon Macroeconomics. "Accordingly, with GDP growth looking sluggish, wages still failing to gather momentum and Brexit negotiations set to reach a climax towards the end of this year, the MPC now looks set to wait until 2019 before raising interest rates again."

Above: Pound-to-Dollar rate shown at hourly intervals.

The Pound was quoted 0.38% lower at 1.3322 against the US Dollar following the release, after extending an earlier 0.15% loss, while the Pound-to-Euro rate was 0.36% lower at 1.1342. Sterling was also lower against all other developed world currencies. 

Above: Pound-to-Euro rate shown at hourly intervals.

Wednesday's data comes after a two month period of losses that have seen Sterling convert a 4% gain over the Dollar into a 1% 2018 loss while the Pound-to-Euro rate has fallen so that a 2.5% gain has become a mere 1% profit for the year to date. The 2018 decline in inflation has been at the heart of this depreciation.

Sterling had performed strongly between February and April as the consumer price index remained close to 3% and the Bank of England warned it would raise interest rates faster and further than markets gave it credit for if the inflation picture evolved in line with its forecasts.

The BoE had predicted in February that UK inflation would remain above the 2% target until at least the end of the first quarter 2021. 

"Inflation is still certainly high enough to justify further tightening, but the BoE just needs to have confidence that economic activity is robust enough to absorb another rate hike," says Jacqui Douglas, chief European macro strategist at TD Securities.

The fall in inflation led the BoE to abandon a May interest rate rise, which has further weighed on the Pound, leaving markets looking to the August Bank of England meeting for the next possible rate hike.

Wednesday's data will be important for expectations in this regard and, according to Capital Economics, will have done littel to reduce the odds of the BoE pushing ahead with another rate rise at some time in the coming months.

"Note too that the MPC predicted in the May Inflation Report that CPI inflation would hold steady at 2.4%, and indeed rise a little further, over the next few months. So there were no surprises here for the Committee either," says Gregory.

A recovery in growth, as well as smooth Brexit process, will also be key to rejuvenating UK inflation and interest rate expectations during the months ahead. This is after UK economic growth slowed from 0.4% in the final quarter of 2017 to just 0.1% during the first-quarter, as poor weather during the February and March period hit both retail sales and construction activity.

"The strength of the UK’s labour market and a Brexit process that refuses to spiral out of control justify at least one hike staying the curve by year-end. Political risk in the Eurozone should also dampen the EUR’s ability to rally. In the event of a weaker-than-expected UK CPI print, I would look to fade the rally in EURGBP," says Stephen Gallo, head of G10 FX strategy at BMO Capital Markets, referring to the inverse of the Pound-to-Euro rate.

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