© Dominic Bryant
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While UK inflation might produce some negative prints in the coming months (our central forecast is that it remains zero or above), the threat of deflation is limited. Core inflation is 1.2%, and the factors that influence it most are likely to push it higher in the second half of fiscal year 2015. Wage growth has begun to pick up and, with the labour market continuing to tighten, upward pressure on wages should build later this year. Hence, the impact of the past appreciation of Sterling is also likely to diminish somewhat from mid-2015. The outlook for growth remains solid and the economy should expand at an above-trend pace this year, leading to a closing of the output gap.
In case inflation were to surprise to the downside, the first reaction of the BoE would be to delay its first rate hike. A rate cut would require a significant shock, such as a renewed and sharp appreciation of the exchange rate. Therefore, this is not something we expect to see.
What could impact the behavior of the Pound in Q2 of 2015?
The Pound remains our second-favourite currency in the G10, after the USD, as we expect the BoE to start hiking its policy rate in Q1 2016 – well ahead of most other central banks. To the extent that this is already priced into the rates markets, Sterling is likely to settle into a range in the near term. Although the election result is unlikely to put the GBP on a new path, the uncertainty surrounding the May general election is also an argument for turning a little more cautious on the currency in Q2.
With no party expected to win an outright majority, a period of post-election volatility is likely, amid attempts to form a coalition or, failing that, a minority government. A Conservative-led government would open up the possibility of a referendum on EU membership. The latter is probably more of a risk to the currency, but we expect favourable economic fundamentals ultimately to support GBP appreciation, despite the uncertainty.
Beyond the election, the key variable to watch is wage growth, as the BoE has signalled it is prepared to look through low headline inflation and raise rates if the amount of slack in the economy continues to fall.Furthermore, any recovery in Euro zone data should ease the BoE's concerns over external risks and may, therefore, prove more of a negative than a positive factor for the EUR/GBP. We expect the EUR/GBP to fall to 0.70 by the year end.
What are your forecasts for EUR/GBP and GBP/USD for the shorter and longer term?
We expect the EUR/GBP to trade at 0.73 the second quarter, whereas we foresee the GBP/USD to reach 1.42 for the same period of time.