As UK inflation rises to 2.9% in August, what impact might this have on UK business?

by Startacus Admin

UK inflation in August hit a 4yr high at 2.9% after being in decline for the previous 2 months. What impact might this have on UK business? Self-employed Financial Market Analyst Fiona Cincotta who had an 8 year career at City Index and now works with them as a freelancer, shares her thoughts on what all this might mean...

"The rate of inflation in the UK in August hit a 4 year high at 2.9% after being in decline for the previous two months. Now the focus will switch to average wage growth figures which are forecast to show that wages are growing at a comparably sluggish pace of just 2.2%, or a pay cut in real terms.

The fact that the cost of living is increasing and denting households purchasing power is not only bad news for the consumer, but also bad news for UK businesses and therefore the economy as a whole. As consumers feel increasingly squeezed they start changing their spending habits and thinking twice about spending on “luxury items”. This change is already presenting itself in retail figures which are also on a downward trajectory. As consumers buy less, fewer staff are required, less cash is sloshing round the financial system and the slowdown filters through the economy. This is a scenario that the Bank of England will be keen to avoid as best as possible.

While a large percentage of these goods are imported and the price rise can still be attributed to 2016’s sharp decline in sterling, this is evidence that the consumer is coming under increasing pressure. If the BOE won’t step in to ease the pressure on the consumer now, then when will it? While we doubt that a rate rise is on the cards for later this week, we believe that there is a chance that the vote split could signal a hawkish shift at the Bank, with the potential for chief economist Andy Haldane to vote for a rate hike. It is also interesting to see how the Governor votes. Although he has been concerned about growth, in a speech in June he mentioned the fact that the BOE could not ignore rising prices indefinitely. Is now the time for the Governor to put his money where his mouth is and actually vote for a rate hike? If yes, then sterling is likely to fly high, with $1.35 a possibility for GBP/USD.

While we may be too soon in our call for a vote for a rate hike from the Governor of the BOE, if inflation continues in this direction then it won’t be too far away. The Overnight Index Swaps market has already rushed to price in a greater probability of a rate hike from the BOE by year end. The market now expects a 30% chance of a hike in December, this compares with 20% a week ago.

Why the BOE may hike before the ECB

We believe that there is a rising chance that the BOE may act before the ECB on hiking interest rates and normalising monetary policy. Firstly, the currency. The ECB “disappointed” some in the market last week by failing to announce when it will taper its asset purchases partly because of the strength in the euro. In contrast, the pound still remains extremely weak compared to where it was just over a year ago. Secondly, although the Eurozone recovery story is in full swing and some fragile economies are finally embarking on economic growth, there are still some weak spots, for example Italy’s growth may have bounced back but its unemployment rate has started to rise again. This means that the ECB needs to tread carefully to ensure it doesn’t stamp out economic recovery. While the UK economy has been subdued, Brexit uncertainty hasn’t triggered a sharp economic downturn and business investment is still holding up well. This gives the BOE more reason to hike rates sooner than the ECB.

The market impact:

Unsurprisingly, yields and interest rate markets have had the biggest impact, with the 10 year yield rising 6 basis points to 1.08%, the 2-year yield has backed away from its high of 0.24%. However, we still think that the 2-year yield can break back above 0.25% in the coming days and help the GBP recovery story, particularly against the euro.

EUR/GBP has suffered heavy losses in the aftermath of the inflation data and it is now testing its 50-day sma at 0.90, below here 0.8930 – the 38.2% retracement of the April low to late August peak – could act as short-term support. Another level to watch is 0.8950 – the top of the daily Ichimoku cloud. A break below this level would suggest a short term end to the downtrend, or it could act as good support if GBP fails to hold onto its mojo.

GBP/USD reached its highest level in a year earlier, although it has backed away from earlier highs. In fairness, if the pound can’t rally when the dollar is this weak then something would be amiss. At this stage, cable moves are as much about USD weakness rather than UK inflation."

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Published on: 13th September 2017