Yes to Brexit, no to rate hikes

Sterling’s rally to an eight-week high above US$1.25 was triggered by a sharp rise in inflation and bumper retail sales data. Consumer prices for February rose 2.3% YoY, the biggest rise in more than three years. This bolstered the view of Kristin Forbes, the lone hawk on the Bank of England’s monetary policy committee, who recently voted for an interest rate rise to 0.5%. Alas, these headline figures are misleading. Yes, the BoE has an inflation mandate. But wages offer a better guide to the likely timing of rate rises.

The reason is that a range of factors can move inflation higher. Depending which one is at play, a price spike can gather momentum, or it can quickly fizzle out. The UK has a highly flexible labour market, and hence it does not tend to suffer cost-push inflation from wage bargaining demands. Instead, the higher prices we see today flow from currency effects and moves in international energy prices. Such price gains tend to be a drag on consumer spending power, and therefore on demand in the economy.

Jacking up interest rates in this environment will simply exacerbate the cyclical downturn that will occur of its own accord.

As policymakers well know, the time to raise rates is when rising consumer purchasing power is creating extra demand, driving higher corporate profitability and therefore a positive feedback loop to higher nominal wages.

The opposite situation is currently at work in the UK, as rising inflation squeezes real wage growth while tighter fiscal conditions also act to dampen real disposable income. Sure, February’s retail sales growth exceeded expectations, yet this looks to be a one-off adjustment after two weak months—a three month moving average shows the slowest growth since September 2014. This downward trend looks to be squarely the result of squeezed real wages due to rising prices. In the UK, retail sales growth has consistently outpaced disposable income since 2013, reflecting strong consumer confidence and a willingness to take on fresh credit.

However, even the most ardent believers in Britain’s ability to thrive outside of the EU acknowledge that the UK’s economy is set to slow down this year. For one thing, the hard reality of its impending departure will weigh on consumer confidence and make shoppers less willing to keep racking up credit card bills, while businesses are likely to pause before making employment and investment decisions.

The sharp drop in the pound has made UK exporters far more competitive and this may partly offset weaker consumer spending. Charles, who remains extremely bullish on the UK’s prospects, made this point last week. Still, I doubt that this resource transfer from consumers to UK producers will be enough for the BoE policymakers to raise rates. For this assessment to change, both nominal and real wages would need to accelerate.

Hence, while sterling may be a long-term buy based on valuation fundamentals, better entry points will emerge. These will likely coincide with a weakening of the domestic economy and the inevitable dark periods that will arise as the UK’s future trading relationship with Europe is subject to highly contentious negotiations.