Bank of England regime shift might inadvertently boost pound

Peter Garnham
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The move from the Bank of England to join the Federal Reserve in linking its monetary policy stance to the unemployment rate has boosted the pound; it might continue to do so as investors adjust to the new regime.

New Bank of England governor Mark Carney set out his plans last week, introducing forward guidance on UK interest rates for the first time.

He said the central bank would not consider raising UK interest rates or reducing the stock of its asset purchases until the unemployment rate had fallen to 7% or below.

Carney tried his best to be dovish, saying the Bank’s  Monetary Policy Committee judges that there is a 50% chance of the unemployment threshold being reached by the second quarter of 2016.

Still, GBPUSD rallied sharply, climbing over 2% from around $1.52 to above $1.5550 on the news.

David Bloom, head of currency research at HSBC, says even though the Bank of England sought to assure the market that it would be a very long time before it tightened monetary policy, sterling had its doubts because of the upward momentum in UK economic data.

UK data have generally surprised to the upside

Indeed, as the chart above shows, economic data in the UK have mostly been better than the market expected over the past few months. As Bloom points out, in particular activity surveys have picked up substantially.

“At the moment the market is seeing excellent UK data, but only moderate-to-disappointing US data and that is pushing sterling higher,” he says.

As it happens, Bloom believes that is a situation that will not persist, and that eventually UK monetary policy will distance itself from the less dovish tone emanating from the Federal Reserve, sending GBPUSD lower in the longer term.

In the meantime, however, there is a new game in town for currency investors.

Steve Barrow, head of FX strategy at Standard Bank, says the Bank of England – like any central bank looking to engineer an economic recovery – would probably like to see a weaker pound. But, he says, in switching the focus of its policy towards unemployment, and away from inflation, it might create the opposite effect.

“The simple reason for this is that the market has continually been too pessimistic about unemployment data in the UK and, if it continues to make this mistake, the pound is likely to rise when employment data are released,” says Barrow.

Before last week, the Bank of England’s monetary policy was inflation. But CPI releases rarely had much impact on sterling.

That is because the effect of inflation on currencies is ambiguous. Higher inflation might be good for a currency if it provokes a policy response. At the same time, it might be bad if it does not lead to higher interest rates, leaving higher inflation to erode a currency’s purchasing power.

As Barrow points out, unemployment data are more clear-cut: better figures tend to strengthen a currency and vice versa.

Admittedly, the pound has not exactly been prone to large shifts following recent unemployment releases, but that might well change now it is the focus of policy.

Indeed, any prospect that the UK unemployment rate – currently at 7.8% – could reach the Bank of England’s 7% threshold sooner, or later, than its mid-2016 estimate is likely to have an impact on sterling.

That becomes important for currency investors given that the market has consistently been too pessimistic over UK unemployment in recent years.

Forecasters too pessimistic on UK unemployment changes

Evidence for this can be seen in the chart above, which shows a comparison of actual outcomes for monthly UK unemployment changes set against the Bloomberg consensus estimates for these releases.

In just about every single month, unemployment data have been better than consensus forecasts, going right back to the start of 2011.

Of course this might change, and admittedly the data show changes in jobless claims, not the unemployment rate, where there is a smaller error.

“Nonetheless, there could be a message in here that the Bank’s shift could bring with it a bias for a slightly stronger pound,” says Barrow.

Just as non-farm payroll figures are the most eagerly awaited economic release in the US, unemployment data are set to take centre stage in the UK. The question for now is whether, from a currency perspective, the shift will be entirely welcome at the Bank of England if it inadvertently strengthens the pound.