High inflation lifts GBP

(23.03.2011) Pound sterling strengthened on high inflation numbers yesterday, and may strengthen further when minutes from the previous Bank of England meeting is published today. Portugal's government may resign today, a development that could weigh further on the euro.

By Kjersti Haugland, Analyst at DNB Markets

british poundAfter a couple of days marked by higher optimism, international stock markets fell again yesterday. USDJPY remains quite stable around 81. NOK and SEK has weakened.

The pound is currently traded at a stronger level than yesterday morning, after the news that February inflation rose even more than anticipated. The rise from 4.0% y/y in January to 4.4% in February has lead more investors to believe that Bank of England's first hike will be delivered already in May. High energy prices are not the only factor to blame: core inflation climbed from 3.0% y/y to 3.4%, which is partly due to higher VTA increases than last year.

Whether VTA increases will contribute to pulling inflation up or down in the medium term is a question of whether British workers will be able to get compensated for their higher living costs through a higher pay slip, or if the VTA will rather be felt as an extra tax which dampens demand for goods and services (and thereby inflation). We believe that the latter effect will be the dominating one. Nevertheless we expect the central bank to deliver two symbolic hikes (one in May, one in September) as a response to inflation remaining far above the 2 per cent target for over a year, due to VTA increases, a weak pound throughout the financial crisis and high energy and food prices.

The UK remains in the focus of market attention today: At 9:30 AM minutes from the monetary policy meeting earlier in March is released. The minutes from the February meeting showed that the minority voting for a hike had increased from 2 to 3 members. The question is now whether more people have joined Sentence, Weale and Dale. According to Reuters the voting is expected to be the same as in February, but the discussion may reflect that the committee is approaching a hike. The last time "most members" agreed that upside risks to inflation had increased the latest months. Members of the majority group, voting for unchanged rate, admitted that the arguments in favour of hiking had strengthened. They did however want to keep an eye on key indicators to see whether the Q4 GDP fall was a sign of a weaker UK economy.

There is little doubt that the British economy is facing difficult times. Finance Minister Osbourne's Budget for 2011 is released today. No significant changes are expected to the plans agreed upon last year. The government will probably have to admit that higher-than-expected inflation and a gloomy growth outlook will dampen household real income growth, and hence also government income.

Its expenses, which are mostly indexed to inflation, will remain unchanged though, and the consequence will be that UK debt will have to rise compared with previous estimates. This is bad news for a country already followed closely by the rating agencies. The large part of the saving measures is not yet implemented, but many of them be so in April. Some examples are higher stamp duty, higher duty on alcohol and fuels, income tax band cuts, the start of two years of pay freeze in the public sector and cuts in various benefits, especially for families with children.

After a long period of strengthening, EURUSD fell somewhat yesterday. The Portuguese minority government faces a decisive vote in parliament today. It has already declared that it will resign if their new and more ambitious austerity measures fail to be approved upon. Yesterday it became clear that such an outcome is highly likely, and the value of Portuguese government debt sank. The developments in this matter will probably weigh on the euro today as well.

Norwegian LFS unemployment is expected to remain stable at 3.4% in January. Our view is that we can expect unemployment to remain stable for a while, with demand for – and supply of – labour growing in parallel.