Carney clarifies wage focus

Sterling endured a tough week following the latest Quarterly Inflation Report. GBP was the worst performing currency in the G10 last week, falling around 0.5%. Granted, that is not a massive slash lower, but it is an acceleration of the move that has been building for the past month or so. We still have a constructive view on sterling moving through the rest of the year but BoE Governor Mark Carney’s comments around wages on Wednesday have upset the sterling apple cart in the short term.

We have no reason to disagree with the argument that the level of slack in the UK economy is decreasing; a falling unemployment rate from 7.6% 12 months ago to 6.4% now, and increases in labour market participation and hours worked and demanded by workers over the same period are testament to that. It is, however, clear that the Bank of England has revised just how much slack in the economy there was, so while we’ve seen a marked improvement, it has been from a very low base.

Comments by Governor Carney in yesterday’s Sunday Times have attempted to mould the market reaction to the Bank’s new found focus on wages. An hour before Wednesday’s Quarterly Inflation Report, the ONS released the latest average earnings numbers that showed a 0.2% decline over the past 12 months. The market’s reaction was to take this increased focus, meld it with the latest data and smack the pound and push expectations of the first hike in interest rates back into Q2. Was it over-reaction? In our eyes, it wasn’t and it was more of an overreaction seeing GBPUSD above 1.70 on the basis of thoughts of a 2014 rate hike.

Carney’s comments have sought to simply distinguish to most people the difference between nominal and real increases in wages. If people are getting paid more, then wages are increasing in nominal terms. If we then discount for inflation and wages are still positive, then they are increasing in real terms. Before Wednesday, wages were still increasing in nominal terms and were close to the level of inflation but still falling in real terms. When Governor Carney talks about raising rates before wages start increasing, it is a rate rise before wages in real terms increase. While we would hope to see wages increasing and workers pushing inflation higher via increased spending in the near-term, unless CPI starts to trip lower then it is unlikely.

The gentle softening of rate hike expectations in Q4 2014 has allowed sterling crosses to come lower in the past month with Carney’s latest clarification pushing the probability of higher UK interest rates by Christmas to around 26% from a post-Inflation Report low of 19%. This week’s minutes will be the key to which way they now trade. We know that the Bank of England’s Monetary Policy Committee has become increasingly split in the past few months as the necessity and desire to normalise monetary policy has increased. This month may be the first in which we have seen a concerted vote against Carney’s policy. This would naturally construe a positive pound that builds pressure on the rest of the MPC to also commit to a change in tack. The release is due at 10.30 on Wednesday.

Friday saw growth confirmed at 0.8% on the quarter, rising to 3.2% on the year – the fastest in the G10. We still believe that this quarter will represent a high water mark for the UK economy and a degree of softer growth to be seen in Q3/4.