GBP: Inflation spike blamed on Brexit, but evidence unclear - MUFG

Derek Halpenny, European Head of GMR at MUFG, suggests that one of the reasons for MUFG being sceptical of predicting further declines in the pound over the short-term from current levels is the continued sense they get of excessive bearishness with a large portion of the market predicting much more weakness for the pound ahead.

Key Quotes

“We still see building upside risks as fears of ‘Hard’ Brexit ease a little and as broader financial market conditions improve.

The latest example of Brexit hype came with the higher than expected inflation report yesterday which was quickly put down to Brexit and the devaluation of the pound. However, there were factors in the inflation report pushing inflation higher that were not Brexit related at all. Firstly, a calculation before Brexit occurred based on assuming a crude oil price would have been able to tell you that the annual inflation rate was going to jump in September. Pump prices fell 2.9% in August and September last year and that fact alone lifted the annual inflation rate with energy prices in August and September unchanged.

Secondly, food prices actually fell in September. Given the turnaround in stock is far quicker with food and given the high import content this is an area where pound devaluation will have a notable impact. The lack of evidence of inflation in food didn’t get much attention yesterday. As we suggested last week, perhaps the ‘Marmite Battle’ between Unilever and Tesco is an indication of how supermarkets will be constrained from passing on as much of the currency-devaluation pass-through as in the past – tough price competition in that sector is good news for consumers.

Thirdly, while we did see goods inflation in the CPI report yesterday, it was notable that there was a large drop in services inflation. Services account for 48.3% of the CPI basket and prices dropped 0.5% in September from August. Admittedly this looks more of an outlier than the norm but nonetheless some softening of services inflation going forward would help offset the inevitable pick-up in goods inflation. Finally, factory gate inflation, also released yesterday was hardly indicating soaring price pressures due to pound devaluation. Price of manufactured products increased 0.2% m/m in September while prices excluding food, beverage, tobacco and petroleum increased just 0.1%.

For sure, higher inflation is on the way. The BoE’s rough rule of thumb is about 25% of GBP change will pass through to prices implying 4.0ppts in total. But whether that is what transpires remains to be seen. The ECB’s rule of thumb was a 0.4-0.5ppt change for every 10% change in EUR EER. But the ECB now admits that was too high given the lack of inflation after the EUR devaluation.

The pound was also helped by the news that parliament will get a vote on the final Brexit plan. But this should not be confused with a vote on Article 50 being triggered. We await the outcome of this week’s court case which will no doubt trump economic news to give the pound direction. We still believe recent pound selling has been excessive fuelled on ‘Hard’ Brexit speculation that will inevitably fade as an influence given the long road ahead in negotiating the UK’s departure from the EU. We also disagree with the view that the pound is not undervalued. Our long-term fair-value estimate is currently at 1.5800 while our short-term models also indicate a spot under-shoot.”