This week, the British Pound rallied more than any other major currency as the Bank of England's hawkish rhetoric on monetary policy caused the market to reassess the future of interest rates in the UK.
While the BOE's Monetary Policy Committee (MPC) kept interest rates unchanged for now, the market focused on the dilemma of Britain's rising inflation but lower real wages amid Brexit uncertainties.
This week, the UK inflation rate was reported to jump to 2.9 percent in July, with core inflation accelerating to its strongest level since 2011. Most of the price increase was in clothing and footwear, and the GBP, which has weakened substantially over the past year, undoubtedly added to this rise.
Additionally, the UK unemployment rate hit a 42-year low of 4.3 percent, which is below the BOE's equilibrium rate. While that number looks impressive, the reality is that real wages have not grown in the UK.
Basic wages rose by only 2.1 percent, lower than the inflation rate, which causes consumer purchasing power and the savings rate to decline. The squeeze in living standards has already resulted in the Trades Union Congress demanding a pay rise across the board for Britain's 5 million public sector workers.
But private sector firms are wary of large wage increases because of the uncertainty surrounding Brexit and a shortage of skilled labor, which leads to lower productivity.
Markets have been watching to see how the BOE would deal with this dilemma. Seven members of the nine-member MPC favored keeping rates on hold, seeing that the average consumer is struggling. The two hawks, however, worry that the central bank will be behind the curve in the rising inflation.
While the majority remain dovish, it was surprising to see the BOE signal that they could withdraw from their monetary stimulus plan over the coming months – a time frame much earlier than the market expected.
Our View: The BOE is probably trying to avoid stagflation. In the midst of rising inflation, if real wages do not increase, then the real economy can turn sluggish, with consumers spending less. The first thing to do in this scenario is to trim inflation. It's likely that the central bank is managing expectations with its hawkish rhetoric – even to the extent of attempting to push the GBP higher, as this will certainly have an immediate effect to trim inflation.
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