London session: The BOE’s Inflation Report and what it means for sterling

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By Kathleen Brooks | February 14, 2013 1:17 AM EST

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Outgoing BOE Governor Mervyn King delivered his penultimate Inflation Report this morning before he leaves in July. Overall, it was a sterling negative report that leaves the door open to more stimulus and predicts inflation to remain above the target rate for the foreseeable future. Here are the highlights from the Feb 2013 Inflation Report

§ UK set for "slow but sustained recovery" this year.

§ The recovery needs to be aided by a further easing in credit conditions and supported by the Funding for Lending scheme.

§ Overall, risks to growth remain weighted to the downside due to on-going "challenges" facing the Eurozone.

§ Weak productivity growth, university tuition fees and increases in domestic energy bills are all adding to inflationary pressures.

§ On Funding for Lending: "growing evidence" lower bank rates are feeding into private sector credit conditions. Overall, still too early to know the full impact of Funding for Lending.

§ Growth outlook: weak in the near-term, but a slow recovery is possible further out due to a sustained improvement in credit conditions, among other factors.

§ The BOE also said the impact of fiscal consolidation in the UK could impact its forecast of a "slow and sustained" recovery that will be weak by historical standards.

§ The CPI outlook is mixed. Inflation is likely to rise in the near-term and stay above 2% for the next two years. This is the first time the forecast for inflation 2-years out has been above 2% since 2008.

§ The inflation outlook is "uncertain" due to potential changes of "regulated" prices, or prices that move due to external pressures like oil prices etc.

§ Wages are likely to remain weak for some time.

§ The BOE has ruled out the prospect of removing current stimulus to bring down levels of inflation, due to the risk that this could derail the economic recovery.

Future policy:

 

§ King said the Bank has the flexibility to help support the economy in future.

§ He also said the BOE will add to stimulus if necessary.

§ Elevated levels of inflation won't be a barrier to further stimulus as King said the BOE will "look through CPI to support the recovery".

Overall, King was fairly candid in his press conference and seemed open to the idea of more policy stimulus. This suggests that David Miles, the lone member of the MPC who has voted for more stimulus in recent meetings, could find others joining his side in the coming months. King mentioned that it is still too early to measure the impact of the Funding for lending scheme. If this can't kick-start the economy then the BOE may have to go back down the QE path and boost asset purchases yet again.

So what would be the conditions necessary to force the BOE's hand on more QE? We list three scenarios that could cause the BOE to extend QE later this year:

1, A flare up in Eurozone sovereign concerns and a sharp rise in financial market volatility.

2, A rise in bank lending costs, making it expensive for private businesses and households to borrow.

3, More economic bad news for the UK and a triple-dip recession.

All three scenarios are possible in the coming months, hence why King is still willing to keep the door open to more QE. Italian elections are a near-term risk, so is a triple-dip recession, especially if we see economic data start to deteriorate again later this quarter. Thus, the market has (correctly, in our view), weighed up that the prospect of more QE later this year as being quite likely, which is pound negative.

Impact on sterling:

 

In our view, this Inflation Report does nothing to stem the pound's decline, and its bleak economic and inflation outlook is a green light for the market to keep selling sterling. The market sold GBP aggressively after the report was released and GBPUSD fell back below 1.5575 - the low from last week. The breach of this support zone is a bearish development and the next key supportive area is 1.5380 - the lows from mid-2012.

The fundamental picture is weak for the pound in the medium-term in our view, however the technical picture suggests that the pace of declines may slow and after today's move the cross is looking oversold. Thus, we could see the bears take a breather. In the short term 1.5575 then 1.5625 are resistance levels. We believe that traders will use any short term recovery in GBPUSD as an opportunity to sell again at better levels, and we look for this cross to continue to decline.

Source: FOREX.com

 

EURGBP has also had a sharp move higher post the Inflation Report. This cross looks like it could re-test 0.8700 in the coming days as the single currency recovers from last week's Draghi blow. However, 0.8700 is a long-term resistance level and a double top, which could be hard to break through and may attract some selling pressure. Also, watch out for next week's Italian election. Any spike in Italian bond yields could weigh heavily on this cross. The RSI also suggests that around 0.87 we could hit overbought territory, which could attract some profit-taking in the short term.

In the long-term we are more constructive of a move back to 0.90 in this cross especially if the ECB continues to shrink its balance sheet at the same time as the BOE looks ready to expand its balance sheet and asset purchase programme.

Source: FOREX.com

Best Regards,

Kathleen Brooks| Research Director UK EMEA | FOREX.com

d: +44.(0).20.7429.7924 | f: +44.(0).20.7929.2010 | M: +44 (0) 7919.411.957 | e: kbrooks@forex.com| w: www.forex.com/uk

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