Wednesday 18th June 2008

King Forced to Put Pen to Paper as Inflation Accelerates Higher

The release of data by the Office for National Statistics (ONS) on Tuesday morning showed that inflation in the UK has reached its highest level since the CPI measurement began in 1997. The ONS confirmed that consumer prices climbed 3.3% in May year-on-year, beating the markets predictions of a 3.2% rise. The increase forced the bank’s governor Mervyn King to write an open letter to the Chancellor for only the second time since 1997, explaining why the rate had strayed more than 100 basis points above the 2% target. In yesterday’s letter King wrote that inflation could stay above 3% for the foreseeable future, possibly exceeding 4%, well above the bank’s previous forecast for inflation to peak at 3.75%.

King pointed towards rising food and energy costs as the main source of inflationary pressures but did predict that, “In the absence of further unexpected increases in oil and commodity prices, inflation should peak around the end of the year and begin to fall back towards the 2% target.” As a CPI rise in excess of 3% had been widely expected, it was interesting to note that the markets reacted counter-intuitively. The implied yield on December short-sterling futures dropped 15 basis points to 6.1% whilst the 2yr GBP swap rate ended the day 20bps lower, indicating that traders are less confident of a rise in interest rates.

The effect on the currency markets was to weaken sterling against the euro and the dollar on the back of renewed doubts over a short term increase in rates. Sterling dropped to 0.7930 against the euro having found earlier resistance at 0.7950 and fell back to 1.9570 versus the dollar. Reaffirming the theory that the markets may have been over-bullish on the chances of a UK rate rise, the FTSE shrugged off concerns over inflation to end the day up 1.2% thanks to a boost from the financial and mining sectors.

In comparison to the UK, the picture on inflation in the US is somewhat less clear following the release of producer price data on Tuesday. Although the headline PPI jumped a slightly more than expected 1.4% last month, the core rate, which excludes food and energy, increased by just 0.2%. On Wall Street the Dow Jones ended the day down 0.9% after figures released yesterday showed that the number of new houses built in the US has reached its lowest level since 1991.

The release of the ZEW index in Germany yesterday showed that investor confidence has dropped to its lowest level for almost 16 years as concerns over a possible economic slowdown appear to grow. It must be noted that of all the major economies, Germany appears to have been one of the least affected by the crisis in the credit markets, and so this drop in confidence could be significant on the back of a strong euro and faltering US economy.

Oil prices eased back from Monday’s record highs but continued to remain comfortably above $130 a barrel on Tuesday ahead of the meeting on June 22nd between the global banks and the major oil producing and consuming nations. Kuwait’s finance minister has followed on from similar views previously put forward by Saudi Arabia by arguing that he would like to see prices go down in parallel with a reduction in price of goods imported to the OPEC countries.

Today see’s the publishing of the minutes from the last meeting of the UK’s monetary policy committee. This could reveal some clues as to the sentiment amongst the central bank’s policy makers ahead of the next interest rate decision on July 10th.

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