Is GBP going to be dragged into EUR's downward spiral?
With the Eurozone being the UK's largest trading partner what happens there has significant influence on the value of GBP. The weakening EUR could well act as a drag on GBP even potentially pushing the Bank of England into easing monetary policy.
Despite it's recent bounce – largely due to short covering – the EUR is widely expected to soon resume its precipitous fall versus the major currencies. This is largely due to the European Central Bank's quantitative easing programme running at EUR 60 billion a month.
Like the Eurozone, the UK may be starting to face deflationary pressures. The February inflation number was 0.0%, compared with 0.3% in January. The BoE's inflation target is 2%.
Interestingly, oil related items contributed nothing to February's fall. Instead that was driven by food, beverages, household goods, furniture, recreation and culture. Those items were cheaper to a large extent due to the big fall in the value of the EUR versus GBP as UK is a big importer of most these items.
EUR/GBP – Eurozone drag on UK
Risk of deflation spreading
So far low price inflation is being seen as a good for the UK economy as it is increasing the purchasing power of consumers and businesses. This will support economic growth as consumers spend more, which in theory should lead to price pressures in areas such as wages and services, bringing the inflation rate back up to 2%.
However, policy makers fear that if deflationary pressures persist they could start to influence prices in the broader economy, leading to even lower wage rises with large purchases for items such as cars and white goods being deferred due to falling prices.
This concern led to BoE's chief economist Andy Haldane, who is often out of tune with his colleagues, to warn that UK interest rates are as likely to go up as down. He also pointed out that the relationship between employment growth and wage rises has weakened – implying that wage inflation may be a long way off, if it happens at all.
BoE monetary policy will be heavily influenced in the coming months by moves in the EUR and commodity prices, which in turn will influence UK domestic prices. The assumption is that these markets will bottom out, probably within this year, in which case deflationary pressures will stabilise and BoE policy won't change that much. This is a view held by the majority at the BoE.
However, it's worth noting that Denmark, Switzerland and Sweden have instituted negative interest rates in response to ECB monetary policy with the latter also launching a quantitative easing programme.
It's hard to ever imagine the UK imposing negative interest rates with its boom prone property market, but with a very uncertain UK election looming in May the chances of UK rate cut (rather than a rise) and even a return to QE (still distant possibility) have become more probable, which is GBP negative for the time being .
By Justin Pugsley, Markets Analyst, MahiFX