The international calendar is crammed this week with key inflation data in the UK, US and China, and preliminary GDP estimates across most of the Euro zone and Japan. The reverberations of Japanese Q4 GDP will be watched with particular interest as markets eye the likelihood of a move back into negative territory.
This week’s Inflation Report could well prompt renewed volatility in sterling interest rate markets. We expect Governor King to provide a rigorous defence of the Bank’s policy to look through the first round effects of a supply shock, remaining focused on the medium-term outlook for inflation. Indeed, King gave the clearest exposition of this policy in a recent speech. Yet inflation developments will complicate this message. The acceleration in inflation above November’s forecasts will necessitate an increase in the short-term inflation profile this time (King mentioned a peak of between 4-5%) and a likely further skewing of upside risks. Yet we will watch the 2-3 year portion of the projection as most relevant for policy. We expect the median forecast to remain below 2%, although it will be important to note the differences between the Bank’s alternative forecasting scenarios (constant and implied market rates) for any implicit validation of the relatively rapid pace of tightening currently priced into the curve. We expect King to justifiably stress the uncertain outlook and, combined with a rise in upside inflation risks, we think this could spark further selling in interest rate markets. Barring signs of second round effects, we doubt key MPC members will be comfortable tightening policy before clearer evidence that the economy is able to withstand the sharp fiscal tightening ahead. Our outlook suggests the sterling yield curve will drop before the next Inflation Report.