Today's Bank of England decision likely to be neutral

The Bank of England, monetary policy committee (MPC) will finish a 2 day policy meeting at midday.
The markets expect the committee to leave its key interest rates unchanged at 0.5%. But the BOE may want to stamp out any risk of inflation getting out of control with a preemptive strike to say 0.75%.

Consumer price inflation rose to 3.7% in December, versus a BOE target of 2%.  The rate is expected to move to 4%-5% over the course of 2011 due to rapidly increasing commodity prices and the rise in VAT to 20% (from 17.5% in January).

The committee is faced with a difficult challenge trying to stifle inflation but not kill of economic recovery completely. A package of austerity measures is kicking in, the VAT rise being the key one, which will dent consumer confidence. At 8%, unemployment remains stubbornly high and disposable income is on a downward spiral as fuel and basic food costs move up.

Inflation, strong services and manufacturing data point to interest rate increases

Strong data from the services sector, which now makes up 75% of the U.K. economy (and 80% of jobs), a resilient manufacturing base, and inflation way above target makes interest rate increases likely as we move into 2011. Despite negative GDP growth in Q4 2010, the services data from January has given reassurance that the winter weather causes the dip in the economy and that a further period of contraction was unlikely. Consumer confidence remains weak with VAT (Value added Tax) increasing in January adding to the tale of woe for households, partly as a result of tax rises but also huge increases in fuel and food costs during 2010 and 2011. The UN released data last week that a basket of food commodities was not at an all time high, and Brent Crude went as high as $103 a barrel due to the potential impact on the Suez Canal due the Egyptian crisis.

Expectations are that U.K. interest rates will rise 0.25% in April or May, with further increases in the Autumn, with a 1.25% rate by the end of 2011. Good news for savers, bad for borrowers! The Bank of England MPC (Monetary Policy Committee) meets on February 9th and 10th. It is considered unlikely that the Committee will increase rates at this meeting, but given the data flow and the headline rate of inflation at 3.7%, which is double the BOE target, increases won't be far away.

U.K. General Election result should drive direction of the Pound

This morning there was an interesting debate on CNBC after the future direction of the British Pound versus the Euro. The Euro has been under pressure over the last few weeks as Ireland, Portugal, Spain and particularly Greece struggle with huge budget deficits and sharply declining GDP’s.

If the Bank of England decides to maintain rates at 0.5% despite the worrying inflation numbers released for December, the pound could come under pressure as other economies raise interest rates faster as their growth recovers faster. This is already happening in Australia and although the U.S. Federal Reserve seems to be reluctant to raise interest rates in 2010, 2011 may be a different scenario particularly if U.S. treasury auctions to fund the huge budget deficit start to become difficult.

Both the Labour government and the Conservative opposition in the U.K. acknowledge the current budget deficit needs to be tackled but detail on is scant as the Election looms this summer. VAT moved back to 17.5% from 15% in January and several tax increases are due to hit in the next financial year starting April but the deficit remains a significant concern for the U.K. economy. The issue of government debt (Gilts) to fund this budget deficit has been supported by the Bank of England’s Quantitative Easing (QE) programme, but this will come to an end this year. In Q3 2009, the Bank of England bought some £97 billion in Gilts as part of QE.

The risk is that this Summer’s General Election will produce a Hung parliament where no party has an overall majority and this will slow down efforts to bring down the deficit. If this happens there will be a double whammy as Gilts continue to be issued and QE slows down to soak up the issue of this debt. The price of Treasury’s will fall as demand drops for these securities and the yield will rise. If the deficit is not dealt with quickly, there is a risk of Credit Rating Agency downgrade, reducing the U.K., triple A rating which again would push Treasury’s lower and the pound. A clear Conservative party win should reassure investors and drive Sterling and government debt prices higher. Therefore the future direction of the Pound seems linked not only to the future movements in Interest rates but are intrinsically linked to the Election. Uncertainty spooks investors, and a party without a clear electoral mandate through a majority in Parliament may be bad news for investors in Sterling.