GBP hit by wage contraction amp dovish BoE inflation report

Today’s release of UK Q2 earnings growth showing the first contraction in four years couldn’t have come at a better time for the Bank of England. As bond markets scaled down expectations for a 2014 interest rate hike, the pound was hit across the board while FTSE-100 pushed higher.  That is exactly what was needed for rate hike chatter to be toned down following today’s release of the sixth consecutive monthly decline in the ILO unemployment rate to fresh six-year lows of 6.4%.

Exactly 12 months ago, the BoE captured markets’ attention by linking possible rate hike to its 7.0% unemployment threshold.  But as the jobless dropped by an impressive 0.8 points in a matter of five months to reach 6.4%, the BoE diverted attention towards economic slack and wage slow wage growth

Slack lowered

The BoE lowered its view for spare capacity in the economy to 1% of GDP from the earlier forecast of 1.0% to 1.5% of GDP. The faster rate of decline in slack is partly explained by the rapid fall in the unemployment rate, but has little implications for policy hawks if wage growth remains negative.

NAIRU also lowered

The BoE reduced its estimate for the equilibrium unemployment rate, aka the non-accelerating inflation rate of unemployment (NAIRU) to around 5.5% from a range of 6-6.5%. This means the unemployment rate could fall by another 15% without inflation threatening to go overboard. If true, then such a projected decline in unemployment will bring about further reduction in slack and ultimately higher wage growth.

Stable inflation

The BoE warned that inflation could drift back above its target in the short run as rates are held unchanged– 2.09% year on year in Q4 2014, 2.23% in Q1 2015 — but will retreat below target to 1.77% at the end of its two-year horizon. As long as the pound limits its recent losses, then any resulting bounce in inflation from tightening labour markets would be capped.

Sterling’s challenge

No central bank report can be completed without the obligatory “hedge” as the BoE reminded that its base rate may have to be raised “more rapidly” than anticipated “depending on data flow”. Today’s wage figures have eliminated rate hike expectations from the 2014 calendar, but have not quite been erased from Q1 2015.

Part of sterling’s 12-month rally is attributed to recent advances in rate hike expectations, but a larger part was due to the accelerating pace of improvement in GDP and business surveys (services, manufacturing and construction).

Although rate hike implications will recede for now, there is no sign of a halt in business expansion. Sterling will likely deepen its retreat ahead of uncertainty related to Scotland’s independence referendum, which may be sufficient reason for an additional 2.0% decline in GBPUSD towards $1.6450s.

The current 75% odds that Scotland will fail to obtain independence should fuel a knee-jerk reaction in the pound, but the implications for further Scottish devolution may raise uncertainties into next year’s general elections. Negative politics and positive economics should boost buying of GBP dips near $1.6400. Meanwhile, preferred GBP shorts are GBPAUD towards 1.7500 and 1.8050 in GBPCAD.