The Bank of England will deliver its first Quarterly Inflation Report of the year on Thursday 12th February. This comes at a time when the global economy is focused on the risks of deflation and a falling oil price. We believe that there is a chance the market could be wrong-footed if Carney fails strike the dovish tone that some expect.
Deflation, deflation, deflation:
The BOE will also release its updated growth and inflation forecasts on Thursday. Since the last report in November, the oil price is down $15 per barrel, which is likely to be reflected in a sharp downward revision to the BOE’s inflation forecast. There is a chance that the BOE’s inflation fan chart could even dip into negative territory, however the BOE may be at pains to state that any period of “deflation” would be temporary and benign and not have a long term impact on the UK economy.
Also released at the same time as the Inflation Report is Carney’s letter to the Chancellor explaining the sub 1% reading in the UK CPI rate last month. Due to this, the Governor may take a cautious stance when it comes to talking about deflation risks, and he may frame his letter to the Chancellor towards longer term inflation expectations which remain stable. Although the BOE’s survey of inflation expectations for the next 12 months has fallen recently, expectations remain at 2.5%, above the BOE’s 2% inflation target. This could be Carney’s get out of jail free card, and help him to defend the Bank’s stance in the face of deflation headwinds.
The bright spot:
Growth could be the bright spot of the report, and there is a chance that the Bank’s growth expectations could be revised higher. Although 2014 GDP was a bit weaker than the BOE forecast in its November report, data for January suggests that the recovery is back on track. The PMI surveys beat expectations and consumer confidence rose to its highest level since August last month.
Interestingly, the Bank may point out that, for now, a falling oil price is benefitting the UK consumer, which could keep growth buoyant for the first half of this year. Expectations of BOE rate hikes have also fallen sharply after all MPC members decided to vote to keep rates on hold in December, previously there had been 2 dissenters. This could also boost growth prospects and keep demand for housing strong for the rest of the year.
What about wages?
The Prime Minister, David Cameron, said earlier this week that employers should share the fruits of a strong economy and give workers a pay rise. Wage growth for November showed wages rose to 1.8% on an annualised basis, the highest level since October 2012. This suggests that a strong labour market is finally starting to filter down to employees. If the PM has any sway over corporate policy (unlikely, we know), then the BOE may say that although the direction that wages are moving is positive, they need to keep an eye on potential inflation risks down the line, which could be perceived as hawkish by the market.
The market has pushed back expectations of a rate hike from the BOE to mid-2016, in our view there is fairly limited scope for a further delay in rate hikes. Due to this we think that the bigger risk is if Carney strikes a more hawkish tone compared to what is expected, which could trigger a rally in the pound and UK Gilt yields could play catch up with US Treasuries.
The impact on the pound:
If the Governor does decide to emphasise wage pressures and stronger growth then we could see the pound break above key resistance. GBPUSD has already broken 1.5274 – the high from 6th Jan – above here opens the way to 1.5353 – the 50-day sma. There is scope for a move back to 1.5486 if Carney strikes a hawkish tone on Thursday.
Key support lies at 1.5197 – the low from Tuesday. In the longer-term GBPUSD could see further upside if we get above the 50-day sma, which would also signal the end of the recent downtrend. In our view there is the potential for pound gains in the coming months as GBP is the second most attractive currency in the G10, apart from the USD, from a growth perspective. If Carney is less dovish than expected that could enhance the pound’s attractiveness.