Sterling needs central bank support to break from lows

The UK economy appears to be recovering since its disappointing first-quarter performance, but the pound remains materially lower today than at any point seen during the financial crisis of 2008-09.

Sterling's rally on Thursday following strong retail sales data was a long time coming for many investors as economic measures for the start of the second quarter have generally put the 0.3% gross domestic product growth of the first three months in the shade.

Second-quarter pick up

Let's take a look at the evidence from this week alone:

• Tuesday: Inflation, long stagnant during the years following the crisis, is now above the Bank of England's 2% target rate, climbing to 2.7% in April and forecast by the Bank to peak at 2.8% in Q4
• Wednesday: Unemployment hits a record low of 4.6% in April; wage growth rises 1 percentage point to 2.4%
• Thursday: Retail sales growth rises to an annual 2.3% in April, following a dismal 1.4% contraction in the previous month

Shopping spree: Consumer spending likely to slow as inflation outpaces wage growth - source: Pexels

What do the data tell us?

Consumer prices are rising thanks to a strong labour market and rising retail sales.

Recent survey data from purchasing managers in manufacturing, services and construction industries show that confidence is not limited to the consumer. Inventories are rising and the outlook for most managers is improving.

The main stumbling point is wage growth. A 3 point gap between inflation at 2.7% and annual wage growth at 2.4% has developed.

This will eventually put a strain on households and reduce their spending power.

"Britain’s labour market is pulling workers in opposing directions – more jobs are being created but both productivity and real wages are falling," says Mariano Mamertino, EMEA economist at global job site Indeed.

What this means for sterling

Economic growth leads to investment growth which supports a country's currency.

Strong growth compels a central bank to be wary – too strong and inflationary and market bubbles form then burst, bringing economic growth to a stumbling halt.

Bank of England: A rise in interest rates is unlikely as the bank believes lower growth will cool inflation - source: Hilson Moran

The central bank's main line of defence is interest rates. Higher rates help cool inflation and support prolonged and smoother economic growth, which in turn supports the currency.

So the accumulation of data this week finally boosted the pound on Thursday. But can it last? Much will depend on the Bank of England's interest rate policy in the coming months.

Bank of England projections

The BoE expects inflation to peak at 2.8% in the fourth quarter, while its growth projections remain modest. Indeed, the Bank believes that the squeeze on households will keep a tight lid on growth and eventually bring inflation back to its 2% target.

Howard Archer at IHS Markit says: "Worryingly for UK growth prospects, the squeeze on consumers looks highly likely to tighten further over the coming months as rising inflation eats further into purchasing power with the pressure reinforced by ongoing muted earnings growth."

Interest rate outlook

While interest rates remain historically low the UK currency looks likely to remain under pressure in the coming months, perhaps years.

Furthermore, major central bank monetary policies are diverging.

The US Federal Reserve is expected to make further interest rate increases this year, which should support the dollar, while the European Central Bank is now being closely watched for hawkish signals, which is propping up the euro.

Despite the single hawk on the Bank of England's monetary policy committee – Kristin Forbes who voted for a quarter point rate rise this month – the UK's interest rate setters appear happy with the current accommodative policy at least for the rest of this year, and likely next.

"Recent survey evidence suggests that employers are planning to offer well below inflation wage increases this year despite what is apparently a very tight labour market,” says Rhys Herbert, Senior Economist at Lloyds Bank Commercial Banking.

“So this week's data are unlikely to convince the majority of Bank of England policy makers that a near-term interest rate rise is necessary."

The pound, therefore, could test new lows in the coming months as the uncertainties surrounding Britain’s exit from the European Union also weigh.