Inflation continued to dominate the market discourse last week, after UK and US CPI figures for June came in well ahead of consensus forecasts. In the former, the headline rate rose to 2.5% year-on-year (forecast 2.2%), while the rate in the latter unexpectedly picked up to a 13-year high of 5.4% (forecast 4.9%). The figures caused some anxiety in the Bank of England (BoE), with two members of the Monetary Policy Committee explicitly making the case last week for removing stimulus measures in the coming months to reduce the risk of inflation holding above target through 2022 and 2023. Over in the US, Federal Reserve Chair Jerome Powell has retained his ultra-dovish position, though even he acknowledged the central bank is “trying to understand whether inflation is something that will pass through fairly quickly, or whether we need to act”.

Despite the somewhat alarming figures, we did not see any major sustained reaction in FX markets in response to the data, with cable (GBP/USD) largely confined to a narrow $1.38-1.39 band last week. GBP/EUR did test a three-month high at €1.175, but the move could not be sustained, and we closed on Friday back below €1.17. Traders essentially remain of the view that elevated price pressures will prove to be a temporary phenomenon and are taking solace from the fact that the current figures are distorted by:

  • Base effects: Prices in the comparison period in 2020 were depressed by lockdowns.
  • Demand-supply imbalances: Suppliers did not anticipate vaccines would be developed and deployed so quickly, resulting in them underestimating this year’s surge in demand.
  • Pandemic related quirks in the data: Lockdowns have altered seasonal patterns in the data, with UK retailers running fewer sales in June than usual for instance.

We too are members of ‘Team Transitory’ and our core view remains that inflationary pressures will begin to decrease in the coming months as demand normalises, supply-side issues are resolved and base effects fade. Looking ahead, we expect that the recent slowdown in commodity price growth and shipping companies’ investment in additional capacity will result in input costs growth moderating by end-year / beginning of 2022.

That said, price pressures do look as though they may prove more sustained than we had thought and risks to our forecasts are growing. One area we are watching closely is housing where there is significant potential for 18 months of below-trend construction activity to feed across into increased rents (both actual and imputed for homeowners). Labour conditions are also tighter than official employment figures suggest, and this is creating headaches for businesses as they are forced to raise wages to attract workers. Enhanced jobless benefits and furlough schemes are a big part of the story and will expire in September, easing the constraint somewhat. However, difficulties may persist beyond this date as the available pool of labour appears to have shrunk in both the UK and US. In the latter, retirement numbers jumped on the onset of the crisis, while in the former there are signs of a post-Brexit exodus of foreign nationals that has meant businesses in lower-paid sectors are struggling to find workers.

We fear that if these factors result in continued upside inflation surprises in the coming months, eventually markets will begin to panic. They may be joined by central banks themselves if we see measures of household inflation expectations continue to climb higher and evidence grows those expectations are becoming de-anchored from the target. Given elevated US price pressures, the focus will be firmly on whether the Federal Reserve will blink or if it will remain committed to its dovish policy. At present, our cable forecasts ($1.45 on a 12-month horizon) assume that the central bank will not move to taper its asset purchase programme until Q1 2021, and rate hikes will be delayed until 2023. However, tightening before year-end cannot be ruled out if US inflation fails to abate, capping the upside for cable over the next year.

Week Ahead

Dollar

The macro schedule has a relatively sparse look to it in the US, with not a huge amount out to influence the dollar ahead of next week’s all-important Fed policy meeting. Flash PMIs will offer some insight on how the US economy is performing in July, though the data’s relationship with eventual GDP growth has weakened somewhat over the past year. In any case, the data are typically not a major mover for the greenback, with markets instead of focusing on the ISM surveys.

Sterling

Monetary policy will remain firmly under the spotlight in the coming days in the UK, with several BoE officials down to speak. Since the release of strong June inflation data last Wednesday (2.5% year-on-year), two MPC members have suggested stimulus measures should be gradually withdrawn to prevent inflation from holding above target over 2022 and 2023. It will be interesting to see if this view is shared by this week’s speakers, with Jonathan Haskel’s speech on Monday of particular importance given the dovish positions he has taken heretofore. Any signs of a hawkish shift could benefit sterling ahead of the central bank’s upcoming rate-setting meeting on August 5.

On the data front, flash PMI figures are expected to point to a modest easing in economic activity in July, consistent with the fading boost from re-opening. Consensus forecasts look slightly too optimistic in our view, with BoE card spending data pointing to a more pronounced slowdown in the services sector as a surge in COVID-19 cases and restrictive self-isolation requirements (500k pinged by the NHS in the week to July 7) act as headwinds. Retail sales figures for June that are also due on Friday are likely to paint a similar picture, with both releases set to pose some modest downside to sterling.

Euro

The key event this week in the Eurozone will be the ECB’s policy meeting. This is the first meeting since the central bank announced the outcome of its strategy review in early July when it raised its inflation target to 2.0% and formally confirmed this target is ‘symmetric’ (below-target inflation is as much of a problem as above-target inflation). ECB President Lagarde has indicated that the text of the central bank’s monetary policy statement will be changed to reflect the new(ish) policy approach, noting that the updated guidance will be “very flexible” and aim to “not start creating the anticipation that the exit is in the next few weeks, months”. Given the central bank has now committed to adopting “especially forceful monetary policy measures” when interest rates are close to the effective lower bound (main policy rate currently at -0.50%), the case could be made that the ECB should be further ramping up its bond-buying efforts under the €1.85trn Pandemic Emergency Purchase Programme (PEPP). However, it is unlikely that the hawks on the Governing Council will acquiesce to such a move, given concerns that core inflation (just 0.9% year-on-year in June) will pick up sharply over H2 2021. Indeed, speculation is currently rife about the future of PEPP, which is due to expire in March 2022, but the rapid spread of the delta variant should give Lagarde scope to delay outlining an exit plan until September. Overall, we expect that the ECB will this week seek to highlight the dovishness of its policy stance relative to the BoE and Fed, meaning the euro could come under some slight downward pressure in the aftermath of the meeting.

Data-wise, the release of the flash Purchasing Manager Indices (PMIs) for July on Friday will also be of some interest. Consensus anticipates the data to point to a further pick-up in economic activity in the eurozone in the month, though we see scope for a downside miss that could see the euro soften. On the services side, the spread of the delta variant represents a major headwind, with several countries (most notably the Netherlands, Spain, and Portugal) re-introducing modest restrictions to combat its spread in recent weeks. Meanwhile, it will be interesting to see to what extent signs of a slowdown in China feed across into softer manufacturing output growth on the continent.

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