GBP: Wage growth? - Rabobank

Sterling softened in response to this morning’s release of the latest UK report as slower than expected employment growth in December, a tick higher in the unemployment rate and the inability of earnings growth to allow real wages to push higher all contributed to the disappointment, explains Jane Foley, FX Strategist at Rabobank. 

Key Quotes

“There was little reaction in the money market.”

“The UK money market is not fully priced for a rate hike in May but, since the hawkish February Inflation Report from the BoE, the market foresees a substantial risk for a move from the Bank this spring. For months the MPC has been assuming that tight labour market conditions will provide a push higher in inflation.  This factor, in addition to its assumption that Brexit will be smooth, could be severely tested in the coming months.”

“Official data continue to show few signs of an acceleration in wage inflation. Average weekly earnings rose at 2.5% 3m y/y in December and haven’t been above this level since late 2016.  That said, last week the BoE’s agents reported that UK workers are set to see their largest annual pay rise in a decade.  Tight labour market conditions are expected to produce worker shortages that finally lift wages.  The Bank’s latest survey of private sector employers indicates earnings will increase by 3.1% in 2018 compares with 2.6% last year, with workers in all sectors with the exception of the construction sector set to benefit.  The assumption is that higher wages will lift real income, boost domestic demand and produce upside pressure to CPI inflation.”

“The Office of National Statistics has thrown some light on why overall wage growth is constrained. In contrary to a popular hypothesis, the ONS suggests that growth in UK employment in recent years “appears to have been more pronounced among associate professional and professional, and managerial occupations” where wages are higher but wage growth has been lower.  It confirms that “the average gross weekly earnings for skilled trades, associate professional and professional occupations over the three-year period grew at a slower pace than on average for all employees.”

“On the other hand, those in elementary occupations; process, plant and machine operatives; sales and customer services, and caring, leisure and other services saw a proportionately higher average wage increase between January 2015 and December 2017. This can be partly explained by a larger proportion of people who benefitted from the rise of the National Minimum Wage and the introduction of the National Living Wage in these occupations”.  If official earning data remains subdued in the coming months, the market is likely to start questioning the ability of the BoE to hike rates more than once this year.”

“The fact that CPI inflation has remained above the Bank’s 2.0% inflation target for the past year is not itself the reason for the Bank hawkish stance. The sharp rise in CPI inflation since the middle of 2016 (when it was close to the 0.5% y/y level) is largely a function of the plunge in the value of GBP following the 2016 referendum on EU membership.  The resultant rise in import prices pushed up the cost of items such as food which eroded real incomes.  The impact of cost push inflation on earnings is similar to that of a tax or interest rate hike.”

“Having purchased food, fuel and other necessities, consumers have less money left over for luxuries and big-ticket items.  This explains why retail sales growth has been trending lower in the UK along with consumer confidence.   Although CPI inflation has been sticky around the 3.0% level in recent months, base effects suggest that the impact of GBP’s 2016 plunge should fade in the coming months allowing UK inflation indices to soften.  That said, it is that Bank’s assumption that domestically generated inflation will be building during the course of this year and this should prevent CPI inflation from dipping significantly lower.”

“Last September the pound was boosted by the indication from the Bank that it was prepared to hike rates. That move followed in November.  At the start of this year, the UK money market was not anticipating the next rate hike from the BoE until the end of 2018, so the hawkish sentiments in the February Inflation Report should have been supportive for the pound.  Sterling, however, has been undermined in recent week by domestic political news and this has the capacity to undermine GBP in the coming months despite the hawkish position of the BoE.”

“When a compromise was announced by the EU and UK in December relating to the legacy issues regarding Brexit, the market assumed that this would pave the way for deal on trade and the transitional arrangements between the two parties. Over the past few weeks, however, the news flow has confirmed that the distance between the two respective negotiating parties remains wide and that the shape of the trade deal is far from certain.  Meanwhile the divisions within May’s government have become increasingly evident.  This factor keeps alive the risk of leadership bid or even an election.  The latter raises the prospect of a far left UK government.  We see risk of EUR/GBP trending towards the 0.93 area this year.  That said, our 12 mth forecast assumes a last minute free trade deal which could provide a sharp boost to the value of the pound.”