Data out this morning from the UK has shone a light on the fragile state of consumption conditions. Retail sales volumes for March showed a hefty 1.4% month-on-month decline, following a downwards revised 0.5% MoM fall in February, as pressures from falling real wages start to rear their head.
Compounding the weaker than expected retail sales data were the preliminary PMIs for April. The initial activity data, on the surface, showed much of the economic slowdown was funnelled through the services sector given its greater exposure to the UK consumer. The services PMI fell from 62.6 in March to 58.3 in April, with the reading undershooting expectations by 1.7 index points. The manufacturing PMI by comparison rose 0.1 index points from 55.2 to 55.3, outstripping expectations of a 1.2 point drop. The improvement in the manufacturing index was largely due to goods producers working through order backlogs more efficiently in April due to easing supply constraints despite widespread reports of renewed supply bottlenecks. Thus, the stronger-than-expected manufacturing index isn’t suggestive of a sustained improvement in manufacturing activity.
On the whole, this morning’s data confirms our view that current pricing of BoE policy tightening is too aggressive.
The FX market reaction this morning is reflective of this finally hitting home for market participants. Without growth conditions improving in the UK, it is difficult to see the BoE joining the G10 pack in front-loading their hiking cycle to contain inflation expectations due to the risk of a policy-induced recession. For the Monetary Policy Committee, the consensus seems to be forming around a more laissez-faire attitude towards tackling inflation expectations, with demand conditions expected to act as a circuit-breaker on higher order inflation effects instead of higher interest rates.
While the retail sales data was telling, it likely foreshadowed a larger collapse in consumption conditions in the UK that is set to take place in the middle quarters of this year. The more timely PMI data partially confirms this: the growth in demand for services has slumped to among the weakest since the lockdowns of early 2021, with higher prices and the associated rising cost of living the principal cause of this. Deteriorating demand conditions should reduce the passthrough of higher input costs to the consumer and thus provide a mild disinflationary effect over the coming months. There are signs that businesses are already experiencing the inability to filter higher costs through to the consumer, largely in the reduction of employment intentions which are moderating due to profit margin suppression.
The PMI reports suggest that there are some indications linking the slowdown in employment growth, which currently sits at a 12-month low, to cost-cutting initiatives by firms. The cost-cutting exercise by some firms is occurring at a time when the rate of cost inflation across the service economy registered the second-fastest pace since the index began.
From a monetary policy perspective, today’s data suggests that there may be merit in taking a more cautious stance on tightening financial conditions. The slowdown in the UK economy should act as a natural brake on the inflation shock becoming more entrenched, thus reducing the need for more aggressive monetary policy actions to moderate expectations of more persistent inflation. This should help the BoE walk the tightrope between tackling current inflation conditions without effectively weighing on the UK economic growth outlook too aggressively. While we expect the BoE to conduct two more successive 25bp hikes as an insurance policy, we think market pricing of a third successive hike, and especially the pricing of one 50bp hike within the next three meetings, is too hawkish given current growth conditions.
Cable breaks two significant support levels today as FX markets adjust to the possibility of more conservative BoE tightening profile
Simon Harvey, Head of FX Analysis