Sterling has appreciated sharply in recent weeks, boosted by UK wages finally showing signs of life, more hawkish MPC comments and (over a longer window) ECB QE. Indeed, the GBP TWI is now nearly 3% above the levels which prompted Carney and Weale to jawbone sterling in March, causing a temporary dip. And the REER is only around 2% below pre-crisis highs. Moreover, relatively healthy UK prospects and potential rate hike votes as August mean that the risks are skewed to further GBP appreciation, supported by prospective policy differentials and possible safe-haven flows. The forthcoming UK EU referendum and the UK current account deficit aren’t troubling FX market participants.
While sterling’s elevated level increases the chances of further MPC verbal intervention (potentially building on Andy Haldane’s comments on Tuesday) several considerations mean this isn’t inevitable. MPC may well conclude that, when analysed in the round, the underlying cause of the GBP rise could be beneficial for the UK. They should also become more tolerant of GBP strength as worries about downside inflation risks continue receding and should attach more importance to GBPUSD than its 18% TWI weight. And they may worry about the effectiveness of verbal interventions in an environment of UK relative outperformance. “Risk management” monetary strategy considerations mean that they may try to slow GBP’s rise, aiming to spread the price level impact over a longer window and thereby ameliorating downside inflation risks, by continuing to stress that the tightening cycle will be slow and limited and try to distance themselves from the FOMC to remain in the dovish central bank peleton for as long as possible. But I suspect that they are likely to be pragmatic about further gradual GBP rise, accepting it as a corollary of the UK’s relatively strong economic performance.
Moreover, near term the biggest GBP upsides seem likely to be against currencies with easing biases – commodity currencies like NOK, NZD and AUD, plus SEK given the Riksbank’s surprise easing and strong hint at further action this morning. But their low/zero weights in the GBP TWI mean that such GBP strength seems unlikely to concern MPC. Further substantial GBPUSD upside also seems unlikely – although expectations of a September Fed liftoff will require an uptick in inflation and wages alongside recent strong employment, consumption and housing data. EURGBP is a tougher call near term in light of ongoing Greek uncertainties: but the risks seem skewed to it falling irrespective of Sunday’s vote given the EUR’s recent funding currency role could resume after a “yes” (albeit with the chance of a near-term knee-jerk bounce) and reduce the chances of a substantial delay in MPC rate hikes while a “no” vote would likely lead to aggressive ECB action (see my post earlier post on the EUR). But EURGBP downsides are more obvious further out, driven by divergent monetary policies: the psychologically-important 0.70 level which was briefly breached on Monday looks vulnerable. And overall GBP seems like a good diversification for USD longs given uncertainties about FOMC liftoff.
Sterling’s recent rise driven by improving labour market and MPC statements
While challenges remain, markets have interpreted recent data and a series of MPC policy statements in recent weeks as once again bringing forward the timing of the first MPC rate hike, thereby supporting GBP via interest rate differentials.
The most important development was the sharp rise in wage growth, particularly in the private sector, as elevated vacancies and evidence of churn seem to be finally feeding through (reinforcing that the low inflation-bargaining risk isn’t materialising). The national minimum wage will also rise 3% on 1 October, with the tight labour market making it more likely to ripple through to non-affected workers. Headline CPI also turned positive after a single negative print, although core inflation again disappointed. But the MPC mantra that inflation is likely to pick up sharply towards end-2015, on base effects, seems to have been bought by the market. And the June MPC minutes had a relatively hawkish take on the labour market, were optimistic on the credit headwind abating and didn’t express any major concern about the upcoming fiscal tightening. Optimistic comments by MPC member Forbes, Cunliffe, Weale and Shafik (i.e. spanning a range of views) added to the dynamic.
Against that, Chief Economist Haldane’s dovish arguments on Tuesday (early MPC liftoff could be self-defeating, recent upside wages news follows persistent disappointments, model ready reckoners imply that the TWI rise will pull down on inflation a little) did not have much impact.
So there is an element of “glass half full” about the market’s interpretation of the wage-price-policy dynamic debate, based upon inevitably limited data. And markets have looked through apparently mixed UK real-side data news (although consumption prospects seem to be improving and the UK housing market continues to be supported by the de facto monetary policy loosening of falling mortgage rates and the May MPC minutes noted growing supply-demand imbalances). Both raise the near-term risk of a temporary GBP correction should data not turn more definitively upwards (Friday’s services PMI will be important in light of the disappointing manufacturing PMI).
And the forthcoming fiscal consolidation could slow the recovery, leading to BoE rate rises again being priced out: the 8 July Budget is a risk event. The market have been sanguine thus far, helped by recent fiscal numbers beating expectations with seemingly no adverse effects on the economy (BoE have also implicitly supported such low fiscal multipliers). Indeed, GBP has been benefitting from strong foreign demand for UK government debt which may increase further with the election uncertainty resolved. And positioning forGBP upside does not yet appear crowded.
Sterling back close to pre-crisis highs
The net result is that the GBP TWI is now nearly 3% above the levels which prompted Weale and Carney to lay into the pound in March. Moreover, GBP valuations look to be approaching stretched levels. The nominal TWI remains around 10% below its pre-crisis peak, but that pre-crisis level was a persistent puzzle inside the BoE. More strikingly, the GBP REER (IMF series extended with GBP TWI moves) is only around 2% below that pre-crisis peak. That may well be causing heads to start being scratched inside Threadneedle Street, especially given their concerns about downside inflation risks and the uncompleted task of rebalancing the economy.
The other relevant fact is that the GBP TWI rise has largely been driven by EURGBP falling in anticipation of/following ECB QE (unsurprising given the EUR’s 47% share in the TWI). The rise in GBPUSD is more recent and has basically only retraced half to fall since mid-2014. Interestingly, option markets suggest that the risks are skewed to further falls in both EURGBP and GBPUSD, which would tend to lead to further GBP TWI rises.
The case for MPC resisting GBP strength: net trade hit and downside inflation risks
And such valuations may well represent a prima facie case for the MPC to start leaning against further GB strength: it hardly seems conducive to stimulating net trade and hence helping rebalance the economy. That said, it’s well-known that international trade is more sensitive to foreign demand conditions than exchange rate fluctuations. And UK export orders have not fallen off a cliff despite GBP’s rise – while the latest CBI industrial trends survey reported a fall in the export orders balance it remains stronger than a couple of years ago – helped by the improvement in EA demand conditions accompanying the EURGBP decline (more on this below).
But MPC have also been keenly focussed on avoiding the recent lowflation environment de-anchoring inflation expectations (and wage bargaining): this is their fear of floating and breaking out of the central bank dovish monetary policy peleton. As Andy Haldane reminded us on Tuesday, the MPC’s inflation forecast features a downside skew. So leaning against further nascent GBP strength could be motivated by the worry that the associated downward pressure on import prices would crystalise that downside inflation risk, with potentially severe costs expectations do become de-anchored (hence why a “risk management” monetary strategy can be appropriate). Indeed, this has been the main motivation for previous MPC comments on GBP strength.
And there are genuine reasons to take this risk seriously, given that three-quarters of the inflation undershoot reflects external factors (commodity price as well as GBP strength). Moreover, there is some evidence that GBP TWI rises are associated with sequences of disappointing inflation outturns (i.e. below Bloomberg median expectations) and vice versa for TWI falls. The link is a little weaker for core inflation (which again disappointed last month) than for the headline rate. But it implies that the market is underestimating the impact of GBP TWI moves on inflation, with the inference that it could continue to do so, although the evidence is necessarily tentative.
MPC may also be concerned about the experience of other countries which have tried to break out of the dovish central bank peleton. Andy Haldane discussed examples central bank policy reversals after early rate rises, with RBNZ being the latest example. Interestingly the NZD TWI only rose about 3% around the rate hike period and is now around 11% below its July-2014 peak. And Haldane’s hypothesis is that the problem reflects the psychological damage on still-cautious consumers and businesses of early rate rises rather than an FX impact per se.
The case for MPC pragmatism: inflation downside risks don’t seem to be materialising, GBP strength isn’t necessarily bad for UK
But the acid test of the worry is whether GBP rises show any signs of de-anchoring inflation expectations. These are more important than the one-off price level effects of a shift up/down in GBP. And here the story is reassuring. In particular, this morning the latest Citi/YouGov survey reported a rise in both near-term and 5-10year ahead inflation expectations. And market-based measures of inflation expectations have actually been better behaved in the UK than in the US or the EA. UK 5y5y inflation breakevens have bounced back sharply even though GBP has been rising, and to a greater extent than US or EA 5y5y breakevens. They also fell less in 2014 in the first place.
So MPC should now be more relaxed about GBP strength than they were back in March when UK breakevens were lower and it was a more open question about whether they would bounce back. Put simply, the MPC’s attitude towards GBP strength will tend to be contingent on the state of the economy and the robustness of inflation expectations. Both seem to have improved in recent months and seem likely to continue to do so as the recovery progresses.
MPC may also recognise that GBP TWI may well overstate the impact on GBP’s moves on UK inflation as the TWI weights do not take account of commodity prices being prices in USD. The TWI weights are measure the UK’s trading links with foreign countries (both direct and third country) rather than an accurate measure of GBP’s impact on import prices. They commodity price angle means that, when considering import prices and CPI prospects, GBPUSD should tend to be more important than the 18% TWI weight. This is important because, as discussed above, GBPUSD is still on balance weaker than a year ago. And, as discussed above, GBPUSD seems more likely to fall (gradually) than other GBP rates.
A deeper point, which I worked on during my time at the Bank of England, is that just considering the impact of GBP moves on UK inflation solely via the lens of import price movements is a very partial thing to do which can overstate the disinflationary impact. Rather MPC should be asking themselves why GBP has risen and considering all the channels via which that underlying development eventually affects inflation. And those wider effects can vary with different underlying causes of the GBP rise: the source of the GBP rise matters in determining its impact on inflation.
The April MPC minutes acknowledged this when they argued that the EURGBP fall, driven by ECB QE, would likely be net beneficial for the UK as it would also be associated with better EA growth prospects. The MPC’s Compass forecasting model does imply that GBP appreciations tend, on their own, to exert downward pressure on inflation and activity. Indeed, Andy Haldane noted that model’s ready-reckoners imply that the recent 3% GBP TWI rise will knock 0.2pp off inflation two years out. He also noted that may outweigh the upside impact of inflation from the recent news from wages. The key point is that he mentioned the two offsetting effects alongside each other, given that they arguably reflect the same fundamental “shock” of wage prospects improving. The conclusion that the GBP TWI impact may outweigh the wages impact could reflect the exercise comparing apples and pears – GBP may be pricing in a higher path of wages (more likely if the labour market has reached a tipping point) whereas only the actual single upside wages surprise is being fed into the model.
But MPC will also likely be cognisant of the difficulties that other central banks (SNB, RBA, RBNZ, Riksbank) have faced in fighting Mr Market about FX levels, although they will also take some encouragement from their limited success earlier in the year. Indeed, this morning Riksbank reacted to SEK’s rise despite negative rates by cutting rates further and being prepared to ease further. And Chief Economist Haldane will be well-aware of the general lesson that success requires actions to back up words.
Of course, we can’t completely rule out MPC concluding that the rules of the game have changed in the downside inflation risks world (following Riksbank’s lead). But the BoE has tended to be reluctant to second guess the market, which are always in some sense “in equilibrium”, except when that is about the timing/extent of MPC rate hikes which they ultimately control. But even this can complicate matters: the February IR implied that the UK yield curve was too flat, which contributed to the GBP rise which Carney and Weale pushed back against in March. BoJ Governor Kuroda’s recent “lost in translation” issues about his views on the JPY REER, and whether that had any implications for the nominal JPY, also suggests caution.
Overall MPC, like most Central Bankers, tend to be more relaxed about gradual FX moves than sharp ones, both because of their source and their impact. Gradual shift tended to be viewed as more likely to reflecting macro fundamentals (and hence should not be resisted) and their CPI price level effect is spread out over a longer window with consequently less impact on measured inflation (and inflation expectations).
As such MPC are less likely to stand in the way of the further gradual GBP rise, if it reflects structural factors and the recovery proceeds as they expect. In other words they will be pragmatic and tend to accept GBP strength as part and parcel of the UK’s relatively strong economic performance.