Next risk for sterling: May’s key Brexit speech this week
This is expected to remain the case for some time, with the CPI rate likely to top 3% this autumn.
At the same time, the economy has slowed sharply this year.
GDP grew by 0.3% in the second quarter, a slight improvement on the 0.2% rise in the first quarter.
This compares to growth of 0.7% and 0.5% in the final two quarters of last year. Clearly then, the economy has lost considerable momentum in 2017.
Meanwhile, the unemployment rate has fallen to 4.3%, its lowest level since 1975, while employment rose by 181,000 in the three months to July, the largest quarterly increase since 2015.
However, this has yet to translate into a sustained uplift in wages. Indeed, earnings growth in the UK, excluding bonuses, has dipped to around 2% this year.
The Bank of England’s task is further complicated by Brexit and the raft of uncertainties that surround it, as well as the volatility of the sterling exchange rate.
However, it is clear from last week’s meeting of its Monetary Policy Council (MPC), that the Bank of England is becoming increasingly hawkish about monetary policy.
Its tolerance for above-target inflation continues to lessen, meaning a rate hike is now likely sooner rather than later.
Overall, the MPC’s latest assessment of the incoming data led it to conclude that, if anything, the remaining spare capacity in the economy was being absorbed a little more rapidly than previously envisaged as the labour market conditions continue to tighten.
As a result, inflation is now seen as being likely to overshoot its 2% target for the next three years.
Against this backdrop, the meeting’s minutes stated that a majority of MPC members judged that, if the growth and inflation outlook continues to develop along their expected paths, consistent with a further erosion of slack in the economy, then “some withdrawal of monetary stimulus was likely to be appropriate over the coming months” for the bank to be able to meet its inflation target of 2%.
Following last week’s meeting, futures contracts are now pricing that a rate hike will occur by March 2018 at the latest.
A further rate hike is expected by markets around mid-2019, which would bring the UK bank rate up to 0.75%.
This marks quite a shift in UK rate expectations in a short space of time.
At the beginning of September, the market was not expecting a Bank of England rate hike to occur until the second half 2019. Now, rates could well be increased before the end of this year.
Sterling rallied strongly following the Bank of England meeting, with the currency gaining around 2% on the exchanges.
This is reflected in EUR-GBP trading at around 88 pence, down from 90 pence before the meeting and a recent peak of 93 pence hit at the end of August.
Meanwhile, GBP-USD hit a one-year high above the $1.36 level, up from $1.32 before the Bank of England meeting and a recent low of $1.28 in August.
The sharpness of the moves suggests that the unexpected rate hike signal from the Bank of England caused traders to close out short positions in sterling.
Going forward, the ebb and flow of information in regard to the Brexit negotiations is likely to be a key factor influencing sterling.
The next big risk event for sterling in this regard is Prime Minister Theresa May’s key Brexit speech on Friday in Florence, where she will give an update on the negotiations with the EU.
Oliver Mangan is chief
economist at AIB.
