Moving into yesterday’s data release, markets were expecting July inflation to be read in the United Kingdom well in excess of 2%. The consensus forecast was 2.3% versus a previous figure of 2.5% in June. Both headline and core inflation came in far softer than expectations at 2% and 1.8% respectively. The reaction in GBP was limited despite the rate of inflation being key to the Bank of England’s stance towards currency-critical monetary policy. The justification for such a limited reaction after the dust settled were the dynamics behind the inflation reading itself. The fall in the headline inflation rate could largely be explained away from changes in clothing prices and household goods. Given the seasonality of such components, especially given the high uncertainty environment in which markets already operate with respect to economic data, the inflation dip was interpreted as the exception that could prove the rule of higher inflation.
The correlation between inflation and the Pound has fallen in recent months. Despite the inflation rate still having a direct impact upon the real yield and therefore perceived cost or reward of holding GBP versus another currency, its role as predictor of interest rates, a more powerful driver of currencies, has weakened. The reason for that is the credibility of the Bank of England and the continued resolve of its Monetary Policy Committee in the face of persistently high inflation readings. Following the departure of the increasingly hawkish BoE Chief Economist Andy Haldane, the composition of the central bank has become increasingly harmonious and resolved around a dovish policy standpoint.
The Bank of England’s latest forecasts point to an inflation rate around and likely in excess of 4% before year-end. The Bank still forecasts inflation of around 3% through 2022. The momentum and dynamics behind inflation still suggest the rate of change in the price level should go well above the month-on-month and annualised figures read yesterday. Despite this elevated level, the Bank still does not expect to raise rates until late next year or early 2023. The market has been slightly in front of the Bank toing and froing with 25bpts worth of rate hikes in 2022. Given that the Bank has forecasted persistently high inflation rates through 2021/2 but seems comfortable to hold current policy instruments stable, they have positioned themselves between inflation and interest rate expectations.
Given the tolerance the Bank of England has shown towards higher near term inflation rates, inflation will serve to deteriorate real yields and therefore even detract demand from GBP rather than act as an indicator of higher interest and thus stronger GBP yields. The correlation should continue to be weak compared with normal levels. What markets will be focussing on is how quickly inflation will normalise in 2022. If inflation is more persistent next year, the credibility of the Bank to park itself between inflation and interest rates will unwind, leaving the market to price in stronger GBP rates given persistent inflation.
Discussion and Analysis by Charles Porter