UK Inflation Preview: Falling and taking rates below zero on its way? Sterling may suffer

• Economists expect the UK Consumer Price Index to have tumbled below 1% in April.
• The Bank of England is watching the data closely ahead of its June rate decision.
• A sharp fall in inflation may prompt setting sub-zero borrowing costs, weighing on the pound.

Does inflation matter when interest rates are already at the zero lower bound and a pandemic is raging? The answer is yes – especially as borrowing costs can dip to negative rates.

Andrew Bailey, Governor of the Bank of England, has left an open door to expanding the bond-buying scheme, and said that it depends on the state of the economy and the lockdown. It has already become clear that most measures to curb the spread of coronavirus are here to stay and that the government's funding needs are growing. The Treasury recently extended the furlough scheme, which is costly. 

A Bloomberg survey showed that the consensus is for another round of £100 billion, topping up the £200 billion announced in March, at the peak of the crisis. With further Quantitative Easing already priced in, the focus shifts to negative interest rates.

Bailey who set rates at 0.10% – the lowest in the bank's multi-century history on his fourth day on the job – did not seem enthusiastic about the idea of negative rates. He only left a small crack open, but two of his colleagues have been more upbeat. Andy Haldane, the bank's Chief Economist, said it is one of the options. Silvana Ternyero, an external member of the Monetary Policy Committee, said negative rates worked in the eurozone.

The specter of negative rates pressured the pound and may do so again – with a crash in inflation raising its chances. A weak rise in prices makes 0.10% a not-so-accommodative borrowing cost.

Economists expect a substantial slowdown from 1.5% yearly in March to only 0.9% in April. The plummet of energy costs is a significant factor, but also a drop in demand. If that forecast materializes, it would put CPI below the financial crisis lows but above the 2014-2015 slide, attributed to the plummet of petrol prices. 

How would sterling react? 

Within expectations: Any level between 0.6% and 1.12 can be considered within estimates. The coronavirus has broadened the range of economic forecasts and raised uncertainty. In that case, GBP/USD would likely trade choppily but probably remain in range.

Below projections: A yearly increase of 0.5% or lower – even if driven by falling oil prices – would place CPI too close to the BOE's interest rate. In that case, GBP/USD would have room to slide, as speculation about negative rates rises.

Above estimates: If headline inflation holds up at 1.3% or above – little changed from March i that would provide hope that demand remains robust, cheering investors. GBP/USD would have room to rise as prospects of negative rates would diminish.

Conclusion

UK inflation figures for April are set to show a considerable deceleration to just below 1%. The closer it falls to zero, the greater the chances of the BOE slashing rates below 0%, and the greater the potential slide for the pound.