Outlook on sterling

It has been quite clear that higher inflation in the UK is not perceived as eroding the value of the pound sterling. Instead, in this nominal world of credible central banks, higher interest rates boost returns and thereby strengthen the currency.

UK inflation has been quite the focus in recent months. Having increased over one per cent in the past year, CPI inflation reached 3.1 per cent last March prompting the Governor to write an open letter to the Chancellor. The following month it ticked back down to 2.8 per cent. However, the headlines in the press continue along the lines of 'has the Bank lost control?' Last month's inflation report highlighted three possible explanations for the pick up in inflation: (i) the gradual pass through of sharp increases in energy prices; (ii) an excess of demand, possibly driven by an excess of liquidity; and (iii) an upward shift in corporate inflation expectations.

The first possibility - the gradual pass through of sharp increases in energy prices - is the most benign. To the extent that corporate profit margins have now been restored, then the pressure to raise prices should have abated. In this case, there is no obvious need for further interest rate rises, or a further slowing in the pace of activity, to overcome the 'problem'.

In this scenario, as inflation falls aggressively in the coming months, sterling would come down as the inflation threat and the threat of higher rates dissipates. The latter two scenarios are more problematic and could require more interest rate hikes and a sharper downturn in activity to return inflation to target. A stronger sterling under this scenario would most likely also be encouraged by Monetary Policy Committee (MPC) members.

The recent surge in inflation has prompted a lot of confusion among financial market participants, both with regards to the inflation numbers themselves and also the reaction from the MPC.

In an accounting sense, a large part of the increase can be attributed to sharp rises in food and gas and electricity prices. However, the UK is soon set to benefit from a decline in retail gas and electricity prices that should drag the headline inflation rate down sharply over the coming months. If this was all there was to the inflation story, then sterling and interest rate expectations should fall aggressively over the next couple of months.

It may not be that simple. Core inflation has picked up and the pricing surveys of UK producers are certainly elevated. The concern is that core inflation has picked up relatively sharply over the past year and further strong gains might follow. So although energy prices will see headline inflation fall sharply in the next few months, the prospects for inflation this year and into 2008 depend crucially on why inflation has risen in the first place. MPC members are divided on which explanation they place most weight on.

How the MPC's thinking evolves with the evidence over the next few months is crucial for the future of interest rates and sterling. It is believed the rise in inflation over the past year is down to a combination of a response to the cost shock and some strengthening in demand.

Core inflation is expected to increase modestly as the past impact of stronger demand through 2006 continues to feed through, before slowing in 2008 in response to slower consumer spending this year.

This outlook for inflation is probably the central projection for the majority of the MPC. However, there are risks, and the consequence of some of them, like the possibility that money growth will lead to an explosion in inflation somewhere down the line or that inflation expectations have become dislodged, are disastrous. So while the chance of these happening could be perceived as relatively small, the consequences are so terrible that the risks are heavily affecting the decision-making.

So despite the benign outlook for inflation over the next few months, the MPC will allow the market to continue to discount higher rates by talking hawkishly and this environment is likely to be a breeding ground for a stronger pound. In this scenario, sterling may very well remain at elevated levels over the short term.

This report was compiled by Peter Calleya, manager Corporate Strategy and Research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.