Sterling and Inflation

ust a month ago, when the Bank of England surprisingly raised interest rates to 5.25% and UK consumer prices reached 3.0%, the pound raced to a fresh 14 year high against the dollar – hitting 1.9915, thus forcing markets to price in two more possible rate hikes in the months ahead. Fast forward to this week, when January’s key inflation numbers were released and the turnaround has proven to be quite remarkable. Given the time lag required for interest rate hikes to feed into consumer price inflation, it is not credible to believe that the Bank of England’s sudden hike a month ago is the reason for a serious easing in inflation in January. That should come in the months ahead.
Let’s look at the figures: producer input prices down 2.0% since December and down 1.6% from January 2006, the annual rate of producer output prices in January eased from 2.2% to 2.1% (obviously cheaper inputs are not resulting in cheaper product for end customers), the annual rate of headline consumer prices eased from 3.0% to 2.7% in the month to January, core consumer prices eased from 1.8% to 1.6%, retail prices eased from 4.4% to 4.2%, wage inflation including bonuses eased to 4.0% from 4.1%, manufacturing units costs down 0.2% in the 3 months to December etc.
February’s Inflation Report suggests that UK inflation will not moderate back to the target 2.0% rate without one more interest rate increase, which oddly enough the report states will not occur until the second quarter. Does this mean further tightening is off the agenda for the Bank of England in March? Apparently so, unless perhaps February’s consumer price data moves back up towards December’s levels. One might wonder, why, if the MPC are so sure inflation will not moderate without one more rate hike, they do not just hike rates in March. Why wait? The MPC are obviously not at one on this question and those members that voted for rates to remain on hold in January will now feel vindicated by this week’s data.
Sterling has largely been in a state of confusion this week, with markets unsure as to whether the currency should be moving up or down. Sterling fell to 1.94 Tuesday against the dollar after that surprising drop in consumer prices, only to jump to 1.9650 Wednesday, following publication of the Bank of England Inflation Report and a broader dollar retreat. We should witness a continuation in the recovery of the euro against the pound though, as the extent of future tightening and interest rate differentials would now seem to firmly favour the single currency, following this week’s data.