GBP: It’s all about the inflation - Rabobank

Jane Foley, Research Analyst at Rabobank, suggests that the spat between Unilever and Tesco regarding the former’s demand for a 10% increase of prices brings the impact of sterling’s plunge dramatically into the consumer space.

Key Quotes

“Quite clearly Unilever will not be alone in feeling the impact of a rise in cost inflation as a consequence of the fall in the pound. Measured since the date of the UK’s referendum on EU entry, the pound has dropped 18% vs the USD and 3% vs the EUR. The BoE’s effective exchange rate is down 15% in the same time horizon which marks multi-decade lows.

Due to the pound’s underperformance, oil prices in sterling terms have risen more significantly than the other currency in the comparison since the early 2016 lows. This is a pattern that will be matched in other USD denominated inputs that will impact many goods suppliers in the UK either direct or indirectly.

At this juncture, it is impossible to know with precision how much of the price increase in imported goods will be absorbed along the supply chain and how much it will be passed along to the consumer. The recent price wars in UK supermarkets have demonstrated how price sensitive UK consumers are and Tesco’s resistance to the current Unilever demands is aimed at protecting its reputation as a low cost outlet.

While large firms may be better positioned to push back against price increases, smaller companies are likely to be more vulnerable. For many UK firms the cost increase associated with higher import prices comes on top of other concerns.

For the UK economy the outlook appears to be one of slower growth and higher inflation. Tomorrow, BoE Governor Carney will have the opportunity to address these concerns when he and some of his deputies host Future Forum, an event which is designed to bring together views and concerns of various UK sectors including those of business leaders. Previously the Bank has indicated that it would be prepared to look through temporary prices rises in order to support underlying demand. However, the risk is that another rate cut from the Bank this year could amplify the downside potential for GBP and lead to a more sustained boost in inflation and inflation expectations. For this reason we expect the Bank to hold rates steady at least through the rest of the year, although the door for further policy support is likely to be left open.

On the back of sterling’s recent plunge, the money market has already priced out the risk of further rate cuts from the Bank and is now positioned for steady rates through into 2018. While a signal from the Bank that steady policy is likely to prevail may lend a little support to sterling in the near-term, it is unlikely to come as a big surprise.

Given that the UK’s large current account deficit has the potential to accentuate downside risks for sterling, the pound will likely be vulnerable to further selling pressure unless the government finds a way to ensure the UK retains access to the EU’s single market in a post Brexit world. We are forecasting a drop to GBP/USD1.18 by the middle of next year.”