UK: Dear Darling

Overview: UK's CPI for May rose by 3.3% y/y. This has caused the Bank of England (BoE) Governor Mervyn King to write an explanatory letter to Chancellor Alistair Darling on why inflation is now more than one percentage point above the Bank's target of 2%. Such a letter had only been written once before. In this letter, Mr King lifted expectations towards inflation for the second half of the year. The tone of the letter was not particularly hawkish and sterling rates fell while the pound weakened modestly. We expect the BoE to be on hold from here before resuming the easing cycle in H1 09.

Details: The UK inflation rate spiked to 3.3% y/y in May. A reading of 3.2% was the consensus expectation in the market. The largest upward contribution to the change in the CPI annual rate came from food and non-alcoholic beverages. There were further large upward effects from housing and household services due to gas, electricity and other fuels and recreation and culture. There were no large downward contributions to the change in the CPI annual rate. The CPI annual rate now stands at its highest since 1992, which certainly is a concern for the monetary authorities.

Excessive inflation is perceived as being undesirable since it puts constraints on economic growth, causes inefficient investment decisions, creates arbitrary wealth distributions and furthermore undermines the credibility of the central banks. So why hasn't the recent rise in prices been avoided?

The remit for the BoE's Monetary Policy Committee (MPC) is to deliver price stability. The MPC has interpreted that as seeking to keep the 12-month increase in the Consumer Price Index at 2% at all times. This is done by setting interest rates at meetings on monetary policy where focus is on the medium term. However, the MPC has several times pointed out that it is not, in practice, always possible to keep inflation at the target.

CPI inflation has previously exceeded the target by more than one percentage point. In March 2007, CPI rose unexpectedly from 2.8% to 3.1% y/y. Subsequently, the Governor Mervyn King wrote an explanatory letter to the chancellor in which he spelled out the background for the letter, the objectives of the MPC, the causes of the rise in inflation, what the MPC intended to do about the rise in inflation and over what horizon the MPC expected inflation to return to target. Higher petrol prices and increasing furniture prices were blamed for the unwelcome rise in CPI inflation. The letter was by no means guilt-ridden and indicated strongly that it was a one-off affair since inflation was expected to fall back to target in the imminent future.

Today's letter contained some important information. Mr King wrote: "The Committee's central projection, described in the May Inflation Report, was for CPI inflation to rise to over 3.5% later this year. But in the past month, oil prices have risen 15% and wholesale gas futures prices for the coming winter have increased by a similar amount. As things stand, inflation is likely to rise sharply in the second half of the year, to above 4%. Mr King pointed out that considerable uncertainty surrounded the projection in either direction. He noted that today's letter was expected to be the first of a sequence of open letters over the next year or so. We think that he is correct on that.

So what policy action will the BoE take? Since December 2007, the MPC has reduced rates three times, to stand at 5%. The Committee has balanced between two risks: inflation and economic growth. The letter was not particularly hawkish despite the current evident price pressures. We think that the MPC will consider the growth going forward and therefore keep rates on hold before continuing the ongoing easing cycle in H1 09. This is, however, against the current market pricing. At present, the markets expect the UK base rate to be raised by 60bp over the next 12 months.

The market reaction has been tangible. After rising modestly on the immediate CPI release, sterling rates fell subsequently. The pound went slightly weaker. After the release of the letter, sterling rates fell further and the pound kept falling. Some had probably expected that he would sketch out some specific action in order to curb inflation rates.

Danske Bank
http://www.danskebank.com/danskeresearch

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