16 February 2004

EZA 582: Sterling outlook

The UK after the inflation report and G7 ­ significant shift in MPC thinking may be underway
The UK after the inflation report and G7 – significant shift in MPC thinking may be underway · Sterling was an obvious winner from both the G7 communique (see EZA report last week) and the MPC tightening move on February 5th. Unlike the ECB and Ecofin concerns about euro exchange rate appreciation, there is no evidence to date to suggest that the Bank of England is concerned about sterling’s recent 2-3% trade weighted (TWI) appreciation – which is to be expected, given the MPC is tightening policy and that sterling remains comfortably below the TWI levels of early 2002. What does seem clear is that the UK authorities would be very reluctant participants in any G7 foreign exchange intervention, should it be necessary. · There is no formal discussion of the impact of recent sterling gains on UK inflation, apart from reference to the gains lowering the inflation outlook in the forecast period. · Compared with the November report, the Bank’s February inflation report shows a more favourable combination of stronger growth (3.4% in 2004 versus 2.8%) but with no deterioration in the inflation outlook, implying a significantly more benign view of the economy’s capacity and output gap (see below). This is a radical change in the MPC’s thinking about inflation, and may prove highly significant in the medium term. Governor Mervyn King did suggest some may find the forecasts somewhat “ Panglossian “ and he did stress the risks and uncertainties around the forecasts. · The Quarterly Inflation Report also shows an MPC projection for inflation over the two year target period, with the projection conditioned on current market expectations for official interest rates. This shows inflation below the 2% target at the end of two years, and below the MPC’s projection conditioned on rates constant at 4%. · This is evidence – albeit not conclusive- that the MPC will tighten less than the market expects over the forecast period and consistent with the MPC’s more favourable view of the growth/inflation outlook over the next two years. · Given the scale of the adjustment to the forecast and implied improvement in the UK growth/inflation outlook, it is unsurprising to find the Inflation report stressing uncertainties about both (a) potential supply and (b) the interest rate sensitivity of the economy. It would be strange if there was not an ongoing debate within the MPC on these key issues for the inflation outlook. · Mind the gap - on the measurement effect of switching to the CPI target from the RPIX, the MPC presumes that the gap between the two measures will narrow to 0.5% in two years, but mainly due to the CPI rising towards the RPIX from the current 1.3%. This seems rather pessimistic, given that house price inflation – which is worth about 0.7% of the gap- is projected to fall to zero over the two years (see EZA Report on UK’s new inflation target, January 2004). · The January inflation data – released on Feb 17th – will likely show the gap remaining around 1.3%, with CPI still at 1.3% y/y, although January price discounting effects increase the noise around the number.

Summary.

Contents
.

Figures
.

© Eurozone Advisors Ltd