Good news on UK inflation has been fairly rare in recent years. Since early 2008, the increase in the overall price level (of 16%) has been around double that seen in both the US and eurozone and the Bank of England governor has been busy writing letters every three months to explain his actions (or lack of them) to the Treasury. So, with today’s fall to 2.8% (from 3.0% in April), the Governor can at least put his pen away. Furthermore, there should be some more good news to come. The main upward pressure in May came from air and sea transport, not a huge element of CPI, but very volatile owing to the calculation methodology (and to the changing timing of Easter), so there is a fair chance that this upward pressure will be unwound in the June data.
The key question is whether this reduction will pave the way for further quantitative easing from the BoE in the near future. Speaking last week, the Governor appeared more amenable but also acknowledged that there had been issues with the effectiveness of past QE episodes, in realising an impact on borrowing costs for both households and businesses. This underlined the activation of the Extended Collateral Term Repo Facility together with the ‘funding for lending’ program being worked upon with the Treasury. The emphasis appears to be on increasing the effectiveness of monetary policy, rather than simply doing more of it. This could well mean that near-term expectations of more QE are disappointed, but more QE appears likely by the August meeting.
There was little surprise to see sterling weaker on the news, but the reaction against both the euro and dollar has been relatively modest, with most of the initial weakness subsequently reversed. Currency markets are becoming more aware that further QE will not have the same impact as past episodes and anyway, on the majors (AUD aside), central banks are all playing a very similar game. Another counterbalance is the on-going eurozone crisis, which has seen sterling benefit in the wider picture. Whilst the euro may still be susceptible to short-covering rallies, the current period of consolidation of EUR/GBP may not last long.