Inflation Data Sends Pound-Euro Rate Towards April Highs, but Gains Could be Short-Lived

Inflation Data Sends Pound-Euro Rate Towards April Highs, but Gains Could be Short-Lived

 Published: July 19th, 2021

The British pound found itself firmly in bid last week following the release of June inflation data which pointed to signs of overheating. The numbers stoked speculation that an interest rate rise by the Bank of England (BOE) in 2022 looks increasingly likely.

According to the UK’s Office of National Statistics, year-on-year CPI inflation rose by 2.6 per cent in June, bigger than the 2.3 per cent forecast by the market and the 2.2 per cent recorded in May.

Following the ONS release, the pound-to-euro (GBP/EUR) exchange rate shot to its highest level since April, but those gains may well dissipate in this week’s trading.

The ONS said rising transport costs, potentially an impact of Brexit and the related loss of tariff-free supply chains were significant factors in driving up inflation.

Changes in the price of motor fuels are another issue, which are also on the rise thanks to spiking oil prices globally.

BoE stays on the sidelines, for now

When inflation figures suggest a faster-than-expect rise, the forex market takes notice. Traders use economic data to gauge if and when central banks will raise interest rates from the record lows seen since the pandemic first struck.

If inflation heats up, central banks typically raise interest to cool economic activity and push rising prices back into check.

When expectations about the timing of an interest rate hike shift forward, the currency in question tends to appreciate.

Current pricing in money markets suggests BoE is on target to raise interest rates in 2022. If so, that will put it ahead of the European Central Bank and even the Federal Reserve’s suggested timeline.

That divergence could support the pound, though the Fed might also need to move faster if US inflation keeps hotting up. Last week’s inflation figures from Washington might explain why GBP/EUR is heading higher while GBP/USD dipped in value over recent weeks.

With inflation tipping over the Bank of England's two per cent target, markets might feel justified bidding for pounds on assumptions of a 2022 interest rate lift.

Economists at Pantheon Macroeconomics told investors last week that the UK’s CPI inflation is headed for slightly above 3 per cent by year-end, ‘though we expect further increases to be driven by energy and food prices.’

For the moment, at least, Threadneedle Street is taking the view that the UK’s inflation blip will prove temporary. Bank policymakers are seeing past the ‘near-term noise,’ and their notes of caution are keeping market expectations on the outlook for sterling and interest rates in check.

A mixed bag of indicators

Sterling’s gains on the inflation data might have been bigger if not for some figures within the release that actually undercut expectations.

These economic input prices point to supply-side pressures that mean demand might have turned a corner. Producer Price Index (PPI) inflation came in at 4.2 per cent year-on-year, below the 4.7 per cent expected by markets and under the 4.5 per cent reported in May.

PPI figures matter because they can surface price pressures earlier in the manufacturing production chain, ultimately being passed on to consumers and impacting the consumer price index (CPI).

The BoE will know that much of the rise in inflation seen so far in 2021 is caused by base effects, whereby the most recent release from the ONS shines in comparison to the unusual slump seen in last year’s prices.

As that 'base effect' starts to fade away, central bankers have a more accurate picture of inflation to work with.

However, the ongoing COVID-19 pandemic and its fallout continue to significantly impact global supply chains, making some raw materials and components very hard to source.

That supply squeeze, in turn, is seen in the higher prices consumers end up paying at the till.

From recent statements, the BoE thinks that both supply-side inflation and the base effect will ultimately disappear, dropping inflation to lower levels in the coming months.

If fuel costs are stoking upside pressure on inflation at the moment, then the recent cooling in global crude prices will be expected to pull those prices back down in 2H 2021.

A risky gamble?

For central bankers, the risk is that some prices prove to be stickier than hoped rather than simply dissipate over time.

Indeed, a looming labour shortage looks to be a regular feature of post-COVID UK economic activity, which will undoubtedly put upward pressure on wages.

Wage-led inflation is a core issue for business growth, and as such, is something Threadneedle Street would have to whack down with higher interest rates.

In their note investors, Pantheon Macroeconomics said that while inflation can be expected to go higher over the rest of 2021, next year will probably see inflation slide back.

‘With sterling’s recent appreciation and a drop in lockdown-induced demand, core goods inflation should ease over the next twelve months, even with an increase in producer output prices.’

Pantheon analysts think CPI inflation will come back to the two per cent target, but not until the second half of 2022.

That would likely take the pressure off the BoE to hike interest rates. If so, it would take a set of stubborn, ongoing inflation readings to move the dial on interest rate expectations for the pound.

New session, new worries

As the new week begins, Sterling will find itself facing a news agenda dominated by reports that double-vaccinated and recently installed Health Secretary Sajid Javid is now having to self-isolate after being infected with COVID-19.

The Health Secretary’s embarrassing plight indicates the scale of ongoing risks to economic recovery wherever the virus continues to extend infection.

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