The Pound’s Slump Adds to Inflation Headache at Bank of England

(Bloomberg) -- The Bank of England faces an extra dilemma ahead of next week’s interest-rate decision, with the slump in the value of the pound threatening to add to resurgent price pressures.

Bloomberg’s SHOK model is similar to the BOE’s own method for predicting inflation in the months ahead. It estimates that sterling’s drop against a trade-weighted basket of currencies since the BOE’s last forecast in the autumn will boost inflation by as much as 0.23 percentage points in the coming quarters.

A weaker sterling is the latest factor to increase the chances of the BOE lifting the outlook for inflation in its Monetary Policy Report on Feb. 6. Policymakers are having to consider both the UK’s stagnant growth and its sticky cost pressures when deciding the speed at which to continue cutting rates.

The pound is the world’s worst-performing major currency so far this year after UK assets were hit by growing concerns over the sustainability of the Labour government’s fiscal plans. While a surge in gilt yields earlier this month has largely reversed, sterling has only clawed back some of its losses.

A weak currency pushes up import costs. Combined with higher energy prices and stubborn wage growth, this means the BOE could warn of inflation topping 3% this year.

However, Labour’s October budget and the threat of a global trade war also loom large over the forecasts, with a weakening growth backdrop threatening to dampen the BOE’s inflation projections in later years. Moves in gilt yields and rate expectations since the budget have tightened financial conditions, a headwind for the economy.

“While December’s 2.5% CPI inflation rate was in line with the Monetary Policy Committee’s forecast, energy prices are up, sterling is down, pay growth has outstripped expectations and the PMI pricing indices jumped sharply in January,” said Chris Hare, senior economist at HSBC. “Taken together, that could lift the Bank’s already elevated near-term inflation forecast, which could see the CPI rate peaking above 3% toward the end of this year.”

Darkening Outlook

The pressures on inflation could pose a policy dilemma for the BOE as it decides how quickly to reduce interest rates.

While predictions of higher inflation are not expected to prevent the BOE from continuing its interest-rate cuts next week, a weaker currency is one of many factors that may entrench a cautious approach to further reductions from Governor Andrew Bailey. He and the rest of the MPC are balancing what could be a temporary spike in inflation with a rapidly darkening growth picture that may dampen inflation later on.