BoE inflation report delays the inevitable

BoE governor Carney’s post-inflation report speech managed to bring down 10-year gilt yields by their biggest decline in 4 months (-3%) despite the release of fresh 5-year lows in UK unemployment rate, hitting 6.8% in March. The fact that average weekly earnings growth held unchanged at 1.7%, undershooting expectations of a jump above 2.0% have also helped temper yields down.

The BoE report reiterated inflation would remain below its 2.0%, while upgrading its 2015 UK growth forecast from 2.7% to 2.9%, while maintaining its outlook on 3.4% GDP for 2014.The message that any rate hike wouldn’t emerge before Q1 2015 was delivered via the BoE’s forecast that unemployment remains significantly above its estimate of current equilibrium of 5.25%-5.75%, which is anticipated in 3 years. That is roughly equivalent to the period over which, productivity growth is expected to regain pre-crisis levels.

Rate hike coming after less slack

Carney’s BoE sought to accomplish one major point: confirming the UK economy is nearing the point of higher rates, but any normalisation in interest would be slow and gradual as much more needs to be done in terms of getting rid of spare capacity -– currently estimated at 1.0% to 1.5% of GDP—and recovering productivity.

Unlike in the aftermath of the last inflation report in November when sterling’s resulting sell-off occurred on the novelty of inflation slowing towards its 2.0% target for the first time in 4 years, today there is nothing on the dovish side of UK data. Unemployment has dropped further below the 7.0%, formerly used as a forward guidance threshold for raising rates, and pound strength will be required to keep inflation stable. Assuming there are no downside surprises in economic figures, the next key data item would be an increase in earnings growth of at least 2.0%, required to achieve positive growth after inflation.

The charts below illustrate there is ample downside ahead in the unemployment rate than in inflation. This further supports the premise that the reaction function in FX markets is more GBP-positive than in the case of USD–as we saw in today’s decline in the US currency and US yields despite a back-to-back jump of +0.5% in US PPI.