Inflation trends in developed economies are starting to diverge, as alluded to here. On the one hand, inflation fears in the US have begun to subside. On the other hand, inflation remains hot in Europe.
Another lead hinting at the same thing arrived today, this time from the UK. Compensation is rising at fastest pace since records began.
More precisely, annual growth in regular pay reached 7.8%, the highest since registrations began in 2001.
This is bad news for the Bank of England. At its August meeting, the central bank raised its policy rate to 5.25% because inflation is well above its 2% target.
In light of today’s wages data, inflation is unlikely to change course any time soon. It currently stands at 7.9%, but wage pressures should push it even higher.
So what does that mean for the British pound?
Interest rate hikes are good for a currency, but only up to a point
The main driver of FX market volatility is a change in the level of interest rates. Central banks raise rates when inflation tends to rise and lower them when inflation cools.
Therefore, changes in inflation trends trigger movement in the currency market because traders anticipate the next movement in interest rates.
Today’s wages data suggests that inflation is unlikely to change direction in the UK any time soon. Therefore, traders increased their bets that the Bank of England would continue to raise the interest rate and, therefore, the British pound should be tender.
So, today’s news is positive for the British pound.
However, there is a very fine line where these dynamics can change abruptly. In other words, higher inflation is only up to a point bullish for a currency.
Take Argentina, for example.
In July, Argentina’s central bank maintained its benchmark interest rate at 97%. Yet, despite the high level, the Argentine peso (ARS) has depreciated sharply.
Inflation in Argentina is 114% annually. Therefore, higher inflation is only good for one currency up to a point.
What is that point? When is the line crossed?
That point is when people lose faith that inflation can be contained. When confidence in the central bank’s ability to contain inflation is lost, anchoring inflation expectations becomes virtually impossible.
Sure enough, the UK is not Argentina. But people shouldn’t underestimate households and businesses who expect higher prices for longer, as reflected in today’s payroll data. It is difficult to get out of this vicious cycle once trust in the Bank of England is lost.
This article is originally published on invezz.com
