While domestic demand looks healthy, short-term political risk continues to dominate sentiment, says Stewart Robertson

Bashed by global weakness and initial sterling strength

Part of the explanation for the recent slowdown is the chronic weakness of world growth. However, part looks attributable to the almost 20 per cent appreciation in sterling seen between 2013 and the end of 2015, according to the Bank of England’s trade-weighted index.

The pound tumbled by 8.5 per cent between November 20th and April 22nd giving exporters a competitive boost. Historical analysis suggests it takes between six to 18 months for the impact of currency changes to be felt on UK export and import volumes, pointing to the effects showing through in the data in the second half of the year.

Heightened inflation risk

In the past the more worrying aspect of sterling depreciations has often been the effect on inflation. The UK is a relatively open economy with exports (and imports) typically accounting for between 25 per cent and 30 per cent of GDP. At the simplest level, a ten per cent decline in the exchange rate might be expected to add between two per cent and three per cent to the equilibrium price level, theoretically boosting inflation along the way. Given the prolonged weakness of inflation in recent years – and indeed intermittent worries about deflation – such a development may almost be welcomed.

The UK has a long history of adverse inflation shocks, many of which have emanated from, or at least been influenced by, a falling exchange rate. Such worries might seem somewhat premature today, but the last large fall in sterling in 2007/8 was followed by the Consumer Prices Index (CPI) rising markedly – averaging around 3.5 per cent between 2008 and 2011 and breaching 5 per cent on two separate occasions. Granted, policymakers’ were grappling with the effects of the financial crisis then, but the depreciation of the pound exacerbated the inflation boost significantly.

With the price of oil and other commodities having rebounded since February and possibly having bottomed, the long period of low domestic inflation might end sooner than some expect. We do not expect an alarming rise in inflationary pressures in the UK over the next two years, but we could see an extended period

of inflation surprising to the upside after three years of tending to surprise to the downside.

A move back above one per cent (on the CPI measure) may come as early as August or September this year, with even the two per cent target achieved in 2017. Other possible influences on inflation this year and next include a return of rising food prices (which are currently -2.2 per cent), a possible resumption of hikes in fuel and alcohol duty in future budgets, the imposition of the sugar tax and the impact of the introduction of the ‘living wage’ on cost-push elements. Furthermore, the labour market continues to tighten, with the internationally-comparable Labour Force Survey (LFS) unemployment rate dropping to 5.1 per cent in the three months to January while the claimant count measure fell to a 30-year low of 2.1 per cent. 

Mixed signals on timing of next rate move

By way of comparison, LFS-equivalent rates elsewhere stand at 5.0 per cent in the US, 6.3 cent in Germany, 7.1 per cent in Canada, 10.3 per cent in France and 22.2 per cent in Spain. In the last year, the UK has continued to generate jobs at a healthy rate, with the number of full-time posts having grown 408,000 in the three months to the end of February when compared with the same period a year earlier. There are now 2.3 million more people in work than at the height of the financial crisis in early 2009. Yet wage pressures have so far remained subdued, reflecting an increase in labour supply that has largely kept pace with stronger demand for workers. In fact, wage inflation is beginning to move slowly higher, although the second half of last year saw a puzzling dip after initially spiking higher. The absence of any significant inflationary pressure has been a factor in the Bank of England’s (BoE) relaxed stance on the timing of its first hike in interest rates since 2007; a message that financial markets have taken to heart - the first rise is not now expected until well into 2018. Although we do not expect an imminent hike by any means, this is stretching dovishness too far. 

Risks balanced, for now

One of the clear consequences of the financial crisis has been a tougher stance towards banks from regulators and monetary authorities around the world; determined to ensure that the excesses that contributed to those events do not happen again. As part of that plan, banks have been required to build capital buffers deemed sufficient to cope with any shocks in the future. This has provoked more tension between the demands for capital adequacy (ratio of capital to assets) and the need for credit growth (increase in those assets) to support economic growth. Achieving that balance is no easy task.

Two of the key benchmarks the BoE scrutinises are the pace of lending growth and the rate of underlying monetary growth. The two are obviously linked and both are rising at an annual pace of between 4 per cent and 5 per cent at present, in line with the growth rate of nominal GDP. It is always difficult striking the balance between enough lending to drive the recovery, with sufficient restraint to prevent asset bubbles inflating too much. The latest readings suggest that trends look about right for now.

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