UK: The appreciation of sterling worries the MPC

The improvement in the UK labour market continued in January, although the figures were a bit weaker than expected. The unemployment rate (3M) in January was unchanged at 5.7% (Danske Bank: 5.6%, consensus: 5.6%). However, as expected, it was a close call as the unemployment rate was 5.66% when including the second decimal place. We are getting closer to the Bank of England’s estimate of the medium-term equilibrium unemployment rate of 5.5%, implying that the slack in the UK labour market is diminishing.

Unemployment has declined by 102,000 persons (3m/3m) and the number of unemployed persons is the lowest since October 2008. The fall is mainly due to an increase in employment of 143,000 persons (3m/3m). Employment is at 30.9m – a record-high. The number of economically active persons has increased by 41,000 persons (3m/3m). The claimant count level is still declining, indicating lower unemployment going forward.

The average weekly earnings figures were disappointing. Average weekly earnings excluding bonus declined for the second consecutive month to 1.6% in January from 1.7% in December (Danske Bank: 1.9%, consensus: 1.8%). Due to some volatility in the series this may not be the start of a new trend but highlights that wage growth is still subdued. That said, real wage growth still increased due to the low headline inflation. The positive real wage growth supports private consumption and hence also the UK recovery.

The Bank of England (BoE) also released the minutes from its March meeting today. The Monetary Policy Committee (MPC) voted unanimously in favour of keeping the Bank Rate and the stock of purchased assets unchanged at 0.5% and GBP375bn respectively. This was as expected as there has been little news between the February and March meetings. For two members the decision of maintaining the Bank Rate was ‘fairly balanced’ (most likely the two hawks, Martin Weale and Ian McCafferty, who have both previously voted for a rate hike).

The minutes repeat that the low headline inflation is mainly due to the falls in energy and food prices. These factors are temporary and should drop out at the end of the year. The minutes states that ‘a central question, therefore, remained whether pay growth, and so domestic cost pressures, would pick up to a rate consistent with meeting the inflation target in the medium term.’ One should therefore watch the average weekly earnings figures closely in the coming months.

The most important news from the minutes is that the MPC has become a bit more worried about the appreciation of sterling. The minutes states that ‘divergent monetary policy trends, as well as stronger prospects for growth in the United Kingdom than in the euro area, might continue to put upward pressure on the sterling exchange rate. This had the potential to prolong the period for which CPI inflation would remain below the target and exacerbate the risk that lower expectations of inflation might become more persistent.’ The UK is more open relative to the US and hence movements in sterling are followed more closely by the MPC. The appreciation of sterling feeds into headline inflation through lower import prices.

We still expect the first hike in August. The economy is growing at a solid pace, the slack in the labour market is diminishing and inflation is mainly being pulled down by temporary factors. As mentioned before, the falls in energy and food prices should drop out of the inflation rate towards the end of the year. Therefore, the Bank of England can look beyond the low headline inflation if the medium-term inflation outlook calls for a tighter monetary policy, as the MPC recognizes that monetary policy works with a lag. However, we stress that risks are tilted towards a hike later in Q3 or possibly in Q4 as wage growth is still subdued and the appreciation of sterling puts downward pressure on inflation through lower import prices.

See the following page for illustrative charts.