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BoE August Inflation Report shakes markets

Wed, Aug 13 2008, 13:20 GMT
by John Hydeskov

Danske Bank A/S

The Bank of England (BoE) released its August Inflation Report at 11.30. As expected, the BoE revised its growth path downwards and the inflation path upwards compared to the May Inflation Report. Although such revisions were expected in general, markets were surprised how negative the report was and also how downbeat BoE Governor Mervyn King was at the following press conference.

The BoE now predicts CPI inflation to peak at 4.9% in Q3. The BoE notes that the inflation outlook is unusually uncertain and that there are significant risks on both sides of the central projection. The key risk on the downside is the possibility that the high level of energy prices and the disruption in credit markets lead to a deeper and more prolonged period of subdued demand, leading CPI inflation to undershoot the target of 2%. The key risk on the upside is the possibility that the period of inflation feeds into inflation expectations and thereby to higher wages going forward. The BoE states that the balance of risks around the central projection for inflation is 'judged to be on the upside'. Furthermore, the BoE notes that 'there is a range of views among the Committee on both the central projection and the balance of risks', meaning that the committee currently is very split, also confirmed by the latest 7-1-1 decision for keeping rates on hold.

On the growth outlook, the BoE states that the UK economy will slow sharply and that production will grow at a very modest 0.1% m/m in Q109. The BoE projection is that output now will be broadly flat in the early part of the forecast period (two years) as sluggish real income growth and constraints on the ability of households to borrow dampen consumer spending, while the weak outlook for demand and the housing market will lead to falls in business and residential investment. In the latter part of the forecast period, the BoE expects economic growth to pick up gradually, as the restraining effect of higher energy prices on demand and output dissipates, credit conditions ease and the lower level of sterling continues to support net trade. The BoE acknowledges that risks around the central projection are on the downside, particularly in the medium term.

BoE Governor Mervyn King was quite downbeat at the press conference and said that: "The growth forecasts are markedly lower than in May", "CPI above target will be temporary", "Near term CPI outlook has deteriorated (after the fall in oil prices)", "Central view isn't for a severe downturn" and "Next year will be difficult".

The market reaction to the Inflation Report was quite strong; EUR/GBP rose from 0.7860 to 0.7930, before falling slightly back. The yield on the 2Y UK gilt dropped around 15bp to 4.52% after the release. These movements are significant, as the reaction to the May Inflation Report, which also had a worried tone and contained some controversial content, was rather limited. In our view, the Inflation Report depicts a pretty fair picture of the challenges confronting UK policy makers. The growth prospects are unusually bleak due to the downturn in housing prices threatening to suppress consumption, but the BoE cannot justify resuming the easing cycle while inflation is still soaring. But as soon as inflation has peaked and starts to come down to more tolerable levels, the BoE can again cut rates. Accordingly, we expect the BoE to lower the base rate down to 4% by end-'09 (base rate currently 5%) in order to stimulate the economy and to ensure that inflation does not undershoot target. Our outlook for GBP underperformance remains. We currently anticipate EUR/GBP to return to territory beyond 0.80 and higher levels cannot be ruled out when the slump in the UK economy becomes clearer.

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Published on  Wed, Aug 13 2008, 13:24 GMT