British Pound Holds Gains Over Euro after Inflation Tops 3%, Folds to Dollar Advance

uk inflation in focus

Brexit news now takes a backseat as the focus turns back to economic data, with November inflation, wages and the Bank of England front and centre.

The Pound-to-Euro rate clung onto the morning’s gains in London Tuesday while the British currency, and most others, folded in the face of an advancing Dollar.

Sterling took around 40 points from the Euro, to be quoted at 1.1359 during noon trading, but ceded 20 to the greenback leaving the Pound-to-Dollar rate marked at 1.3327. Traders bid the Dollar higher Tuesday in response to strong US producer price data and in anticipation of a Federal Reserve rate hike Wednesday.

Price action comes after the UK consumer price index posted a surprise increase for the month of November, taking it above the crucial 3% threshold for the first time since April 2012.

November’s CPI measure means the Bank of England governor will now need to write a public letter to the chancellor setting out how the Monetary Policy Committee intends to return inflation to its 2% target.

The consumer price index rose to 3.1% in November, from 3% in October, against market expectations for a steady reading of 3%.

Rising prices for air fares as well as recreational goods, notably computer games, were behind the upward move according to the Office for National Statistics report.

Core inflation, which removes volatile food and energy goods from the basket, held steady at 2.7% for the month.

Tuesday's data is important for Sterling given that future Bank of England interest rate rises will be contingent upon inflation remaining above the 2.0% target throughout the multi-year forecast period.

"All in all, there is little here to suggest that the MPC needs to raise interest rates again quickly to stamp out inflationary pressures. Indeed, we think that CPI inflation has probably now peaked," says Paul Hollingsworth, an economist at Capital Economics.

However, the rub for Sterling bulls is that increasing numbers of economists now expect inflation to begin falling back from the 3.1% peak seen in November, as the effect of the historic 2016 fall of the currency drops out of the prior year comparison.

"It would also be helpful for economic growth going forward if inflation is close to peaking. The BoE currently expects inflation to peak at just over 3.0% before the end of this year, which will be tested by the release today of the latest UK CPI report for November," says Lee Hardman, a currency analyst at MUFG.

The Bank of England raised interest rates in November for the first time in a decade to combat rising inflation, while its inflation report projected that the Consumer Price Index would still be above the 2% target at the end of the forecast horizon.

Market expectations for the path of UK interest rates, and therefore the fate of Sterling, will be dictated largely by how far and how fast inflation falls.

Wednesday’s wage data, which comes ahead of Thursday’s Bank of England meeting, will also be important for Sterling in the context of Tuesday’s inflation report.

"Tomorrow’s wage growth figures are likely to indicate that underlying cost pressures remain subdued too," adds Capital Economics' Hollingsworth.

Higher inflation, which is itself the result of the post-referendum fall in the Pound, is the principal driver behind the fall in “real incomes” that has pressured the inflation adjusted value of consumer spending and “real GDP” in recent quarters.

It is therefore, the driver behind the economic slowdown that so much has been made of in recent times. But Wednesday’s data will be important for another reason too.

A return to “real wage growth”, where pay packets grow above the rate of inflation, could encourage the Bank of England to think that underlying inflation pressures will be sufficient enough in coming years to keep inflation close to its 2% target. 

This might then beget expectations of more interest rate rises, which would be positive for Sterling.

The Pound-to-Euro exchange rate was quoted 0.11% higher at 1.1345 following the release, after reversing an earlier loss, while the Pound-to-Dollar exchange rate was marked 0.15% higher at 1.3366.

"GBP/USD liquidity appears solid and upside is likely to have limits given the size of the unknowns ahead for the Brexit deal," says Neil Jones, head of corporates & financial institutions group for MENA & Central Asia at Mizuho Bank.


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