January 17th 2012: Preview - UK inflation decline will offer buying opportunity
In more normal times, Sterling would come under pressure on weaker than expected inflation data. The situation is anything but normal with the UK currency continuing to gain important defensive support from Euro-zone fear. For now, the UK is safe from credit-rating downgrades which is continuing to attract capital and any spike lower on weaker than expected headline inflation data should be seen as a Sterling buying opportunity.
Headline UK Inflation edged lower to 4.8% in December from 5.0% and there should be a further sharp reduction at the start of 2012. Principally, this will reflect technical factors as prices rose strongly at the beginning of 2011 when the sales tax was increased. This hike will start to come out of the annual calculation in January and there will be an important impact in cutting the inflation rate with a further effect in the February data. There has also been some downward pressure on energy and transport prices over the past few weeks. The retail sector will be important as discounting has also been a key factor with prices cut aggressively in order to boost sales volumes.
The most likely outcome is that there will be a weaker than expected inflation release. This would provide a fig-leaf for the Bank of England to justify further quantitative easing within the next two months with the current round of bond purchases due to be completed in February. The bank will clearly welcome any inflation decline, although it remains the case that inflation control has long been abandoned as the battle to keep the debt-ridden economy afloat has had to take precedence.
Monetary developments remain extremely troubling for the central bank as money supply fell again in December, maintaining the very weak trend seen during the past few months. This lack of growth is a clear sign of continuing stress within the banking sector as lenders pull back on loans. There has been further evidence from the high street that banks are cutting loan facilities and this is threatening to intensify the raft of closures.
The monetary data, therefore, suggests that inflation is not a significant problem at this stage as the banking sector is not strong enough to provide any transmission mechanism. Indeed, deflation is likely to be a more serious shorter-term threat as banks continue to restrict lending. From a medium-term perspective, the risk is likely to be completely opposite as inflation will be the only escape route from the debt burden which will leave Sterling dangerously exposed. The compass could change direction very rapidly, but it should not be a near-term threat.
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