Market Analysis - Whats in Store for Sterling?
¢ CPI inflation – another rise. CPI inflation moved up to 4.7% in August from 4.4%. This was in line with our forecasts, but a touch greater than consensus estimates of 4.6%. The principal reasons behind the latest move were well rehearsed – food and non‑alcoholic beverage prices jumped another 1.3% on the month, taking the year‑on‑year increase to 13.0%, while gas and electricity prices soared by 11.5% and 4.3% respectively, higher utility costs adding 0.3% to the overall inflation rate. However there were some signs of wider price pressures creeping through, especially via household appliances and selected household goods and through personal care and financial services. Indeed the ‘core’ rate (which excludes energy, food, alcohol and tobacco), nudged up to 2.0% from 1.9%, while services inflation reached 4.3%, a near 3‑year high. Lower petrol prices, which fell by 4.6% on the month, helped to contain the increase.
¢ Peak next month? With a further effect from higher domestic power prices to come through, we are still of the view that CPI inflation will rise a touch above 5.0% next month. Thereafter we maintain that a combination of favourable base effects, commodity price falls and a recession in the domestic economy will pull inflation down sharply. Signs of higher prices in certain areas of the service sector and elsewhere are not good news, but wage costs are still only rising modestly and it is feasible that the slowdown in the economy is not sufficiently developed to squeeze domestically generated inflation. We are still forecasting that CPI inflation will fall to below 2% in a year’s time. While this is admittedly contingent on a moderation in service price inflation, we are comfortable with our view.
¢ The Governor’s new open letter. With today’s data confirming that CPI inflation has continued to exceed 3% for another three months, Mervyn King was required to write another open letter to Chancellor Alistair Darling. King repeated the view in last month’s Inflation Report that the committee was expecting inflation to peak close to 5.0%, higher than anticipated in his letter in June, the main reason being higher import prices. The Governor added that firmer commodity, energy and import costs only represented a shift in relative prices, but that the MPC was committed to ensuring that this would not lead to a sustained rise in general inflation through allowing faster increase in other costs such as pay. King mentioned that although inflation would peak soon, it would stay ‘markedly above the target until well into 2009’.
¢ A difficult balance? The Governor recognised that higher inflation risks had to be balanced out against the effects of the weak economy. However he also said that that the ‘Committee has become firmer in its belief that a period of muted economic growth is necessary to dampen pressures on price and wages and return inflation to the target in the medium‑term’, although the MPC was ‘aware that the slowdown in activity that is already in train could, if severe, result in inflation falling below the target in the medium-term’.
¢ Not planning to cut rates, but… Overall the tone of the Governor’s letter does not convey the impression that the MPC is about to cut rates again. The letter was penned yesterday and so King would have been aware of the situation regarding Lehman Brothers, and he did explicitly say that the committee would pay due regard to the latest developments in financial markets when setting rates. This is certainly a wildcard. We do not claim to have a perfect crystal ball into whether the post‑Lehman situation will result in a protracted period of additional financial stress, but this certainly has to be a risk as its balance sheet is unwound and as investors potentially become more risk averse.
¢ More money market help… The Bank of England has been proactive in trying to relieve this week’s new wave of money market tensions. Today it added an additional £20bn in a ‘Fine Tune’ repo, following a £5bn injection yesterday. This appears to have helped to an extent, but given the performance of bank stocks (for example, HBOS shares were 31% down today at the time of writing) the market perception is that a number of banks will struggle. If developments continue to move in this direction, then the MPC will be forced into easing policy again, perhaps soon, much in the way that it suddenly brought rates down towards the end of last year, despite its current concerns over inflation.
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Regards
Alex Thompson-Rohe
