Coming Surge in UK Inflation Expected to Keep Sterling Buoyant

Coming Surge in UK Inflation Expected to Keep Sterling Buoyant

 Published: October 22nd, 2021

UK inflation has been less sharp than economists had forecast; however, new figures released by the Office for National Statistics (ONS) on Wednesday, 20th October, suggest markets are starting to price-in expectations for a surge in prices, while the Bank of England says it’s set to raise interest rates.

Forex analysts believe sterling will stay supported as a result.

Headline CPI inflation was softer than expected, increasing by 3.1 per cent in the year to September. That’s just under the 3.2 per cent posted in August and widely expected by consensus.

Core CPI inflation, meanwhile, came in at 2.9 per cent, a touch below the 3.0 per cent economists and markets were looking for.

Having those figures arrive below expectation could suggest a mechanical move lower for sterling, which was slightly down against most G10 majors at the time of writing.

The expectations for higher inflation in the near term, however, are widely shared by analysts, who believe the figures won’t have a marked impact on BoE rate policy.

Analysts at Capital Economics told the Financial Times that the ONS inflation figures for September ‘probably won’t lower expectations that Threadneedle Street is set to raise interest rates before year’s end.’

Both core and headline numbers show inflation is notably above the bank’s 2.0 per cent target and even higher than the 3.0 per cent forecast by the bank’s economists back in August. If coming prices rises appear as expected, it could stay well above the target for months to come.

‘GBP is up against EUR and USD,’ said Commonwealth Bank of Australia’s Currency Strategy Unit in a weekly briefing. ‘The pound could still edge up because the BoE is likely to act on runaway inflation than either the ECB or the US Fed.’

The ONS said that headline inflation was subject to downward forces thanks to 'base effects,’ meaning that September’s YoY inflation is being compared to a period of unusually high price rises, corresponding with the end of the UK’s ‘Eat out to Help Out’ restaurant scheme in 2020.

This statistical anomaly may have acted to flatten the inflation numbers artificially.

How will the BoE respond?

The Bank of England's Monetary Policy Committee has indicated that UK interest rates could go up as the central bank looks to allay expectations by consumers and businesses that an entrenched period of high prices is here to stay.

While the BoE recognises that the key drivers behind current inflation are being caused by supply-side issues caused by the sudden return from pandemic lockdown, there is a concern that not taking action could allow inflation to become embedded elsewhere in the economy.

The rising-rate hike expectations have acted to lift the pound higher against other majors.

Western Union said in a note to investors that GBO is ‘on a tear’ due to rising expectations that the BoE will deliver an interest rate hike before Christmas.’

The pound to euro (GBP/EUR) exchange rate rose to its highest levels in 20 months on Tuesday (19th October) and sits at 1.1851 at the time of writing.

The pound to dollar (GBP/USD) rate also rose to its highest level in over a month, reaching 1.37 on Thursday.

Helping push CPI higher was rising fuel prices. The average price of petrol was 134.67 pence per litre in September 2021 versus 113.6 pence per litre in September 2020. This year’s price is the highest per-litre price seen since September 2013.

The ONS says long queues at the nation’s petrol stations at the end of the month likely weren’t captured in the statistician's data window, so it will factor into next month's numbers instead.

The resurgence of air travel has also given inflation an upward push, along with rising prices and valuations for second-hand cars.

While hotels and restaurants had a downward influence on prices (the Eat Out To Help Out effect discussed earlier), there are signs that hospitality is beginning to see sharp upward spikes.

The UK Food and Drink Federation, the industry body which represents hospitality businesses, made a submission to a Westminster committee on Tuesday (19th October) that inflation in the sector was currently running at up to 17 per cent as businesses grappled with the combined impact of soaring wage, energy, and ingredient costs.

'Hospitality pricing is often a predictor for what’s coming in retail. With industry inflation running at between 15 and 18 per cent, the implications are terrifying.’

How high will UK inflation go?

Financial researchers Pantheon Macroeconomics believe CPI inflation will peak at roughly 4.6 per cent in March after Ofgem, the UK’s energy regulator, approves the next set of energy price rises. The firm’s researchers told Bloomberg that inflation would likely peak in early April at five per cent.

‘The backdrop is that that inflation is giving the BoE’s policymakers a headache, especially as the energy price surge shows no signs of abating. Recent bank announcements indicate an interest rate hike is on its way soon.’

‘The bank’s monetary policy committee will probably avoid aggressive tightening as the economic recovery still ends time to embed itself in what continues to be a fragile economic landscape.’

Money markets have priced in a rate hike for November, with potential for up to three hikes next year.

Economists at Berenberg Bank told Reuters that BoE policymakers ‘are obviously aware of market pricing’ when they make such announcements, and that needs to continue. ‘It would be a serious failure in communications if the Bank of England suddenly decides to hold off until 2022 for a rate rise.’

After November, Berenberg is looking for a second hike of 25bp in February, with a third 25bp hike likely in the second half of 2022.

By their estimates, the bank rate is forecast to rise to 0.75 per cent by the end of next year.

Would raising interest rates this year be premature, requiring a reversal by the bank further down the line?

Berenberg thinks that’s unlikely. ‘In our view, markets have probably overreacted to recent Bank of England guidance, which has been ramped up in recent weeks.’

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