England’s Consumer Price Index (CPI) showed an increase in prices of 2.9% over the last year. Up from 1.9%, last month’s annual reading, this is the largest ever increase in the annual rate between two months.
The Office for National Statistics reported the rise was due a sharp decline in prices back in December 2008.
The largest upward pressure on prices were in transport and clothing and footwear. There were no significant downward pressures on CPI.
Source: Office for National Statistics
The Bank of England (BoE) has a 2 percent inflation target. However, it is not their aim to always have inflation at 2 percent. The bank’s “Monetary Policy Committee’s aim is to set interest rates so that inflation can be brought back to target within a reasonable time period without creating undue instability in the economy.” So a rate hike is not required, and the next decision on February 4, 2010, is likely to hold once again.
It is likely that next month’s CPI data will be less than 2.9 percent, simply because it won’t include the extremities of December 2008. So that takes some of the impact out of this news.
Market sentiment can go different ways with a significant increase in inflation. The typical perspective is bullish, thinking that inflation will motivate the central bank to raise rates, which is done by contracting the money supply, which results in a stronger currency. However, with the relatively small economic growth being attributed to low rates and stimulus, most central banks will be reluctant to raise rates at first, even in the face of inflation. Raising rates would restrict the growth that is currently taking place.
If there is inflation, but no sign of the central bank raising rates anytime soon, which appears to be the case, then it can have the opposite effect. Inflation by itself means a currency is weakening. If next month’s CPI data is near 3 as well, then the market will begin talking about how the central bank is stuck, the possibility of stagflation, and that will weaken the GBP unless the central bank starts indicating rate hikes are in the near future.
The GBP responded by strengthening. GBPUSD first spiked up to 1.6456, then fell steadily for a couple of hours to 1.6310 on USD strength, before climbing back up to levels before the news. EURGBP continued its steady decline as the German ZEW Economic Sentiment disappointed. GBPJPY also rallied. Despite the current strength, the challenges ahead of the BoE causes me to be cautiously bearish the GBP.
