Talking Points:

All Eyes on BOE Inflation Report to Set the Near-Term British Pound Trend
Sterling Likely to Fall if the BOE Opts to Lower its Target Unemployment Rate
Unchanged Guidance to Boost GBP, But Follow-Through May Disappoint

The release of the Bank of England Quarterly Inflation Report is in focus in European hours. The central issue at hand is the fate of policymakers’ forward guidance framework introduced last year, which pledges to keep interest rate hikes off the table while the unemployment rate is above 7 percent. The last edition of the Inflation report released in November 2013 put the jobless rate at 7.4 percent in 2014 and 7.2 percent in 2015, implying the policy lending rate will remain at its current setting at least until next year.

Reality has proven this forecast to be too pessimistic: the unemployment rate fell to 7.1 percent in November and private-sector analysts are now expecting the 7.0 percent threshold to be reached by the fourth quarter of this year (according to a survey of economists polled by Bloomberg). How the BOE intends to adjust for this disparity will be critical for the direction of the British Pound going forward.

Three possible scenarios represent the spectrum of outcomes that may be ahead:

Scenario 1 (GBP-Negative): When introducing its forward-guidance regime, the BOE may have intended to keep rates low for a period of at least several years and used the 7 percent unemployment rate threshold as a time marker based on its forecast for when that level may be reached. Reaching that line in the sane sooner means policymakers must move the goalpost to deliver the same message, lowering jobless rate target. That would cement the probability that low rates will prevail for a long time yet, an outcome that is likely to broadly weigh on Sterling against its top counterparts.

Scenario 2 (GBP-Positive): Policymakers genuinely believe that the slide in the jobless rate reflects an unexpectedly rapid improvement in the pace of economic recovery, meaning it may see it as appropriate to raise rates significantly sooner than previously thought. A revision of the Bank’s economic forecasts that telegraphs such a world view coupled with an absence of change to the guidance framework stand to furnish the Pound with a relatively supportive monetary policy profile compared to most other major currencies, sending it higher.

Scenario 3 (GBP-Neutral): The policy-setting MPC committee has a bit of wiggle room on the 7 percent threshold in that it has routinely stressed that crossing it does not represent a rate-hike trigger. Rather, seeing the jobless rate reach this barrier and overcome it would bring the possibility of rate hikes into the conversation. From there, when tightening might actually materialize would be a data-dependent matter. Telegraphing this message would call for adjusting official verbiage to reflect how long rates might remain at current levels, mirroring the Fed’s expectations that “it likely will be appropriate to maintain the current [interest rate setting] well past the time that the unemployment rate declines below [the FOMC’s target of] 6.5 percent.” In this case, the Pound is likely to see some near-term gains reflecting the absence of an overt guidance change but follow-through maybe limited.

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