GBP rose after the Bank of England clearly made the financial case for remaining in the EU while their inflation forecasts suggested the pound and interest rates are underpriced at current levels.
The Bank of England’s May Inflation Report proved to be a positive event for the British pound which rallied on a combination of factors.
In light of recent soft UK data many in the market were expecting an axe to be brought down on the Bank's GDP forecasts. When the Bank announced a downgrade from 2.2% to 2.0% the GBP rallied in relief as markets believe this to be a benign cut.
Interest rate forecasts remain consistent with inflation hitting the 2% target set at the Bank by 2018. In fact, markets are told they are under-estimating the potential for interest rate rises over coing months by pricing both sterling and UK yield futures at current levels.
However, it was Carney's unambiguous message on the economic and financial risks surrounding a vote to leave the European Union that caught the attention of the markets. The Bank stated:
“The most significant risks to the MPC’s forecast concern the referendum. A vote to leave the EU could materially alter the outlook for output and inflation, and therefore the appropriate setting of monetary policy. Households could defer consumption and firms delay investment, lowering labour demand and causing unemployment to rise.”
“At the same time, supply growth is likely to be lower over the forecast period, reflecting slower capital accumulation and the need to reallocate resources. Sterling is also likely to depreciate further, perhaps sharply. This combination of influences on demand, supply and the exchange rate could lead to a materially lower path for growth and a notably higher path for inflation than in the central projections set out in the May Inflation Report.”
The BOE made it clear the report was written from the perspective of the UK staying in the EU.
In the ensuing minutes following the release, the pound rose by 16 hundredths of a dollar to 1.4463, buoyed both by the anti-Brexit message which is expected to support the stay campaign and by higher inflation forecasts which suggested markets were underestimating the chances of inflation rising more quickly in the medium term.
Growth Forecast to Fall – Brexit Uncertainty Blamed
Threadneedle Street downgraded growth in Q2 to 0.3% from 0.5% previously and lowered forecasts for the economy in the second half of 2016, with whole year GDP growth lowered to 2.0% from 2.2%. This was based on the larger-than-expected hit to production in the early part of the year, due mainly to Brexit concerns.
“In the Committee’s latest projections, activity growth recovers later in the year, but to rates that are a little below their historical average. Growth over the forecast horizon is expected to be slightly weaker than in the February projection. The May projection is conditioned on a path for Bank Rate implied by market rates and on continued UK membership of the European Union, including an assumption for the exchange rate consistent with that.”
The report saw inflation reaching its 2.0% target by mid-2018 and expected a rate rise at some point during that period:
“Consistent with the projections and conditioning assumptions set out in the May Inflation Report, the MPC judges that it is more likely than not that Bank Rate will need to be higher by the end of the forecast period than at present to ensure inflation returns to the target in a sustainable manner.”
However, they reiterated that the bank rate would rise “gradually” and to a “lower rate” than previously. New-new still in.
Inflation forecasts were revised up marginally to 2.07% in two years’ time (from 2.05% prev) and down 2 basis points to 2.23% in three years (from 2.25% previously).
Monetary Policy Remains Unchanged
The BOE monetary policy meeting minutes were released at the same time as the Inflation report and revealed that the board voted to keep rates unchanged at 0.5% and asset purchases continuing to renew at a level of 375bn.
The board was unanimous in its judgement to keep rates unchanged, with Ian McCafferty a previous dissenter not disagreeing on the matter in May.
The minutes contained new references to conversations amongst policymakers concerning the devaluation in sterling since late 2015, with most agreeing that 50% of the 9% decline had been as a result of Brexit risks.
The minutes showed that the Governor in particular underlined the risks of leaving the EU. That pay levels remained subdued; that there was more slack in the economy than previously thought; that the negative impact of strong sterling was past its peak, and that external factors posed less of a risk than before.
Vicky Edward of Capital Economics said the Inflation Report showed higher inflation forecasts but weaker growth, and that this was a message to markets that they were not pricing in the possibility of higher interest rates adequately:
“Indeed, as in the past few Reports, inflation is projected to be a bit above its target in the medium-term – once again sending a warning to financial markets that their interest rate expectations are too low. “