MNI INSIGHT: Sterling Blurs BOE Policy; Doubts On May Hike

By David Robinson

     LONDON (MNI) - The Bank of England Monetary Policy Committee's (MPC's)

widely anticipated May rate hike is now shrouded in doubt, with uncertainty over

sterling and the extent and magnitude of the pass-through from its

Brexit-related depreciation to consumer price inflation thickening the fog, MNI

understands.

     In a BBC interview that ran Thursday, Bank Governor Mark Carney indicated

that MPC members could well split over a May hike. The two MPC members who voted

for a hike in March, Ian McCafferty and Michael Saunders, are unlikely to back

down -- underlined in a speech by Saunders earlier Friday.

     "I am sure there will be some differences of view but it is a view we will

take in early May, conscious that there are other meetings over the course of

this year," Carney said.

     Sterling Overnight Rates (SONIA), which at one time had been pricing in an

over 90% of a May hike, are now attaching around a 55% chance.

     Carney's comments sent sterling lower and sterling's volatility could

impact the BOE's inflation models ahead of the May Inflation Report.

     The Bank's research has highlighted the irregularity of the speed and

magnitude of the pass-through from currency moves to headline inflation. The MPC

had assumed a prolonged upward effect on consumer prices from the Brexit

depreciation but it overestimated, as inflation and imported inflation pressure

may be fading faster than expected.

     --DOWNSIDE INFLATION SURPRISE FOR MPC

     Former BOE MPC member Kristin Forbes led Bank research into exchange rate

pass-though which highlighted the irregular effects of currency moves on

headline inflation. She set out how the nature of the shocks which move the

exchange rate were key to the relationship to prices, with supply, demand and

policy shocks having varying effects.

     The Bank took on board Forbes's work and MPC members' best collective view

was sterling's Brexit related depreciation would impact prices over four years. 

     The February MPC minutes acknowledged that members were aware that they may

have got it wrong, noting a possibility that the contribution of imported

inflation pressures would diminish more rapidly than in the central projection.

     First quarter inflation outturns suggested that this may have happened.

Headline CPI came in at 2.5% on the year in March compared to the Bank estimate

of 2.8% and over the first quarter averaged 2.7% compared to the February

Inflation Report projection of 2.9%.

     If inflation does return fairly swiftly to around the 2.0% target, that at

the very least makes communicating the case for a May hike trickier.

     --MPC COMPROMISE ON STERLING FORECASTS

     While the MPC wrestles the likely pass-through from sterling, it also has a

problem in factoring in the currency's move into its inflation predictions. 

     The MPC has an idiosyncratic approach to projecting where sterling is

heading, resulting from an esoteric split among its members in 1999.

     Then member Sushil Wadhwani asserted that the Bank's approach of relying

uncovered interest parity (UIP), whereby exchange rates are assumed to move in

line with interest rate differentials, performed worse than random walk (RW).

     A person familiar with the debate at that time told MNI that the MPC was

evenly divided on the issue and then Governor Eddie George refused to rule one

way or the other and the MPC decided to take an average between the current

sterling level, as implied by RW, and the path implied by UIP - a convention it

still follows. 

     In the February Inflation Report, it projected that sterling on its

Effective Exchange Rate Index (ERI) would virtually flat-line. The inflation

forecasts were conditioned on sterling edging up from its Q4 2017 outturn of 78

to 79 in Q4 2018 and staying there through to Q4 2019.

     The sterling ERI was running markedly stronger than this, at 80.6723 on

Wednesday, but it was knocked hard Thursday by Carney's BBC interview.

--MNI London Bureau; tel: +44 203-586-2223; email: david.robinson@marketnews.com

--MNI London Bureau; tel: +44 203-586-2225; email: les.commons@marketnews.com

[TOPICS: M$B$$$,M$E$$$,MX$$$$,M$$BE$]