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Last Friday, the UK reported a surprise growth in GDP. That was even a surprise for the normally overly optimistic government analysts, who were expecting the UK to remain in recession for the coming quarters.

Of course, it was just one month of data and that doesn’t necessarily mean a trend is forming.

The outsized growth was driven primarily by the service industry, which coincides with better sales reported by leading UK retailers. It suggests that UK shoppers are feeling the pinch of inflation, but there hasn’t been as much demand destruction as anticipated. That comes in the context of a still-tight labor market despite ongoing strikes and an expected drop in inflation.
 

The labor market still exerts pressure

Average wages in the UK have continued to rise given the low unemployment rates. So far, average growth has been below the inflation rate, which helps alleviate worries about a wage-price spiral. However, it could mean that reducing the core rate in the long term might prove more difficult. The headline inflation rate is so high that what would otherwise be a worrying increase in average wages appears to not be a problem.

UK Claimant Count for December is expected to fall to 16.0K, almost halving compared to 30.5K reported in November. Despite strikes demanding higher pay and benefits, employers are apparently still hiring. Meanwhile, the unemployment rate for November is expected to remain steady at 3.7%.
 

Inflation is finally coming down

On Wednesday, the UK is expected to report another modest drop in the headline inflation rate for December, at 10.6% compared to 10.7% in the prior month. This could be interpreted as the BoE’s tightening policy finally starting to work and could prompt more members to switch to the hawkish side. Currently, the market is pricing in a 50bps hike for when the BoE meets at the start of next month. That compares to about half as much expected in the US.

Other countries have experienced significant drops in headline inflation as fuel prices have come down, but not the UK. Analysts are expecting the drop to be driven by core inflation, which doesn’t include food and energy costs. Core inflation is expected to drop to 6.3% compared to 6.4% prior. The drop in energy prices is expected to be offset by increases in food costs.
 

Where things are going

Another issue on the docket this week that could substantially move the pound is that UK and EU representatives are said to be near to reaching a deal in principle to address the Northern Ireland Protocol. It wouldn’t be a final agreement but would resolve a couple of the key issues, particularly with taxation in Northern Ireland.

The surge in optimism and reduction in risk if such a deal were to be reached could support the pound. On the other hand, given the expectation building around it with the numerous press reports, if some kind of deal isn’t reached, it could be viewed as a significant diplomatic setback.

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