GBP: Higher wages? - Rabobank

Jane Foley, Senior FX Strategist at Rabobank, explains that one of the most interesting parts of last week’s BoE Inflation Report was the market’s reaction to it as it is possible that investors were sceptical about the legitimacy of the Bank’s assumptions of a smooth Brexit and an increase in wage inflation, though it is equally possible that the short-covering pressure that has lent GBP support for the past two months is running out of steam.

Key Quotes

“The Bank argued last week that the factors that are currently weighing on wage growth are unlikely to persist.  Textbook economics implies that when the unemployment rate drops to a certain level, labour shortages emerge and wages are pushed up.  Higher household incomes then boosts demand which draws prices higher.  In recent years, however, economists have had to adapt this theory.”

“In recent years technological changes have reduced demand for many middle-skilled workers in the US and Europe, this has pressured pay for many and led to fairly static household incomes.  This is linked to weak demand growth and soft core inflation (which is a decent proxy for demand).  The existence of structural impediments to wage growth argue against the Bank’s assumption that earnings will push noticeable higher soon.  That said, it is possible that Brexit will create labour shortages in some sectors that will put some upside pressure on wages.  This scenario, however, would bring into question the Bank’s assumption that Brexit will be smooth.”

“With only weeks to go before the UK general election it is unsurprising that the BoE wants to avoid being caught up in more wranglings over Brexit related forecasts.  For this reason, the Bank probably had little option but to assume that the Brexit process will be smooth.  However, the question of how to avoid a hard border between the Republic of Ireland and the North and the issue of the size of the Brexit bill show little sign of resolution.  In addition, it is next to impossible to contemplate that a trade pact between the EU27 and the UK will be in place in two years’ time in line with the specifications of Article 50 of the Lisbon Treaty.  Assuming that Brexit will be smooth is thus very contentious.”

“Despite the demands of PM May, her objective for a free trade pact with the EU27, is not compatible with the EU’s prerequisite of acceptance of the ‘four freedoms’.  A fall back to WTO trade terms would bring large tariffs for sectors that include cars, dairy and pharmaceutical and non-tariff restrictions for serve sector.  Last week, the argument that last year’s drop in the value of the pound would offset the addition cost of tariffs for exporters wavered with the release of worse than expected UK trade data for March.  Also contradicting this argument is the findings of a CIPS survey published yesterday.  The survey finds that 46% of European businesses expect to reduce their use of UK suppliers as a result of Brexit.  In response, 36% of UK business will beat down their prices.  This is likely to be another impediment to wage inflation.”

“Looking forward wage inflation will be a crucial lead indicator for BoE policy.  It is our view that the risks to growth stemming from Brexit, soft wage inflation and weak aggregate demand could keep BoE rates on hold potentially through the whole of 2018.  Since the market is still very short of GBP, we would not rule out further squeezes higher.  However, we would be looking at rallies above GBP/USD1.300 as selling opportunities and expect cable to be trading around the 1.25 level at the end of the year.”