- "All else equal, this would result in a slightly lower path for inflation than envisaged" - Bank of England on the Pound's recovery and its impact on inflation
The Bank of England's December policy decision is the last major set-piece for Pound Sterling in 2017, and no changes to policy were announced.
The Bank met expectations with its decision to keep interest rates on hold at 0.25% and maintain its current target for bond purchases.
That means it will still buy and hold GBP 435bn of UK government bonds and GBP 10bn of corporate debt too. The decisions were unanimous.
However, all eyes were on hints regarding future direction of monetary policy and a mixed, if ambigious, communique gave no concrete hints as to when the next move on interest rates would be.
The Bank kept its neutral policy stance, repeating that monetary policy can respond in either direction to changes in the outlook.
The fact that Sterling was unable to take a decisive move following the event confirms the Bank is happy to keep its cards close.
What we do know is that policy-makers are happy with the prospect of looser fiscal policy in the United States under Donald Trump.
The minutes to the meeting noted:
"Since November, long-term interest rates have risen internationally, including in the United Kingdom. In part, this reflects expectations of looser fiscal policy in the United States which, if it materialises, will help to underpin the slightly greater momentum in the global economy evident in a range of data since the summer."
But, it was also observed that, "the global outlook has become more fragile, with risks in China, the Euro area and some emerging markets, and an increase in policy uncertainty."
Recovery in Sterling Makes the Bank more Comfortable
The big question for the Bank was however always going to be what they made of the trajectory in inflation which is on its way up, as evidenced by this week’s data release.
With a mandate to target inflation at 2% news that it has shot higher to 1.2% of late will raise questions of how the Bank intends to deal with a potential overshoot.
Typically strong inflation is cooled by raising interest rates - costlier borrowing tends to slow economic activity and thus cool prices.
It is also a positive to the domestic currency which tends to benefit from an inflow of foreign capital as investors become eager to take advantage of the higher yields on offer.
Therefore, any hint that the Bank is uncomfortable with the rate of increase in inflation would see markets price in an interest rate on the horizon which could well see the Pound move higher.
On this front the Bank expects inflation to rise to the 2% target within six months.
"Since the Committee’s previous meeting, sterling’s trade-weighted exchange rate has appreciated by over 6%, while dollar oil prices have risen by 14%. All else equal, this would result in a slightly lower path for inflation than envisaged in the the November Inflation Report, though it is still likely to overshoot the target later in 2017 and through 2018," read the statement.
This is actually quite bearish for Sterling in that it betrays the sense that the Bank is not worried at this stage and is not leaning towards a pro-GBP interest rate rise.
Nevertheless, markets expect the next move to be up when it comes to rates.
Since the August inflation report - when interest rates were cut - markets have been steadily now projecting 50bps of hikes by 2020.
Back in August they were expecting the policy rate to remain at 0.1-0.15% through to 2020 which suggests we have seen a trend towards expectations for higher rates in the future.
Both hard and soft data so far point to a continuation of growth momentum in the short term.
The GBP has appreciated c.5% in trade-weighted terms from its October lows but remains 16% lower y/y.
However, anecdotal evidence about business investment and the BoE’s own survey shows business investment and hiring intentions are weak.
“We expect data to gradually deteriorate as the Brexit negotiations move ahead in 2017," say Standard Chartered which brings into question the bullish pricing of bond markets.
If Standard Chartered are correct then Sterling is looking too expensive at current levels.
Indeed, analyst Viraj Patel advocates selling GBP/USD on an apparent mismatch in pricing:
"We do not expect the BoE meeting today to spur any major surprises, with Bank rate staying unchanged and two-way risk to policy reiterated. However, it seems that markets have recently adopted an “inflation nutter” approach, a termed once coined by Mervyn King alluding to a central bank's overemphasis on inflation at a cost to the real economy. Dovish BoE repricing risks in 1Q17 makes GBP a sell."
It appears analysts are at odds with market pricing - and if the analysts are right then the Pound and interest rate expectations will have to fall.