While keeping UK interest rates on hold, the Bank of England (BoE) sent a strong message on Thursday for investors to expect more rate tightening in the not-too-distant future.
An accelerating global growth backdrop means the UK economic outlook is still much better than many had feared.
However, it's by no means all good news on the economic front as part of the BoE´s justification for a more hawkish outlook is that the UK economy is less able to grow without stoking inflation than it was in the pre-crisis years.
The BoE´s Monetary Policy Committee unanimously voted at its February meeting to keep interest rates unchanged at 0.5%.
But it was the BoE´s emphatic warning that UK interest rates would likely need to be “tightened somewhat earlier and by a somewhat greater extent” that caught investors' attention.
The pound immediately jumped against the dollar after the minutes of the February meeting were released.
UK government bond yields also rose sharply as investors priced in higher interest rate expectations.
“We now expect the BoE to increase rates at the May meeting. And given the Bank’s suggestion that rates will need to rise by a “greater extent”, a second hike in November certainly can’t be ruled out,” said James Smith, an economist at ING.
The reason economists were a little surprised by the BoE´s statement on Thursday was that the UK´s major economic ill of 2017, namely accelerating inflation, has been tipped to subside in 2018.
Indeed, while still well ahead of the BoE´s 2% target, UK inflation eased to 3% in December compared to 3.1% in the prior month.
And, as the BoE points out in its statement today: “Sustained above-target inflation remains almost entirely due to the effects of higher import prices following sterling’s past depreciation.”
In other words, it was the post-Brexit depreciation of sterling that saw inflation shoot up over the course of 2017.
Currency depreciation tends to have a delayed, albeit potent effect on domestic price levels. The sharp depreciation in the pound following the Brexit vote in 2016 took some time to work its way through.