Markets speculate that the prospects of further rate rises in the US are diminishing and US inflation figures seem to confirm this view. In the UK, on the other hand, expectations are heading in the opposite direction, with implications for sterling.
By Michael Baxter, Economics Commentator for The Share Centre:
Following dovish comments from the Fed chair Janet Yellen earlier this week, today's data on US inflation makes the prospect of a further interest rate hike increasingly unlikely.
US inflation was unchanged in June – 1.6%. Tellingly, inflation minus food and energy was 1.7%, with this index rising by just 0.1% in June, compared to the month before. Month-on-month US inflation, less food and energy, has now been 0.1% for four months in a row. The inflation fears seen earlier this year appeared to have gone into reverse, reducing the need for an increase in US interest rates.
This supports the more dovelike commentary from Ms Yellen, in which she suggested that price pressures could either rise or fall, and that inflation risks are 'two sided'. This is a change in tone from her comments throughout most of this year, when she has implied that US interest rates were likely to carry on rising.
By contrast, in the UK, inflation was 2.9% in May, and many expect it to rise further. In the last meeting of the Bank of England's Monetary Policy Committee (MPC), three of the eight members voted for higher rates, and since then, two members of the committee who did not vote for higher rates, the Bank of England's chief economist Andrew Haldane and its governor, Mark Carney, have intimated that they are coming around to the view that UK rates may need to rise soon.
This reversal in views from the FED and Bank of England, which seems to support the diverging direction of inflation in the two countries, could be supportive of sterling relative to the dollar.
In fact, US interest rates are now much higher than in the UK, furthermore, this is likely to remain the case for some time. Seen in this context, the new views coming out of the UK and US central banks may not seem especially radical, but the markets have been surprised. They had priced in a quite different prognosis for UK and US rates for the next few months, and when the markets are surprised in this way, currency markets can be affected.
Much depends on what happened to UK inflation in June – and we will have an answer to that next week.