Inflation trends in developed economies start to diverge, as mentioned here. On the one hand, inflation fears in the United States have begun to recede. On the other hand, inflation remains hot in Europe.

Another clue that hints at the same thing came today, this time from the United Kingdom. Pay is rising at the fastest pace since records began.

More precisely, the annual growth in regular pay reached 7.8% – the highest since records began in 2001.

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This is bad news for the Bank of England. At its August meeting, the central bank raised the bank rate to 5.25% because inflation is well above the 2% target.

In light of today’s pay data, inflation is unlikely to change course anytime soon. It currently sits at 7.9%, but wage pressures should push it even higher.

Interest rate hikes are good for a currency, but only up to one point

The main driver in the FX market’s volatility is a change in the interest rate level. Central banks raise the rates when inflation trends higher and lower them when inflation cools down.

Therefore, changes in inflation trends trigger movement in the currency market because traders anticipate the next move in interest rates.

Today’s pay data suggests that inflation is unlikely to change direction anytime soon in the UK. Hence, traders increased their bets that the Bank of England would keep hiking the interest rate, and thus, the British pound should be bid.

So, today’s news is positive for the British pound.

However, there is a very thin line where these dynamics may abruptly change. In other words, higher inflation is bullish for a currency only up to one point.

Take Argentina, for example.

In July, the Central Bank of Argentina held its benchmark interest rate at 97%. Yet, despite the elevated level, the Argentina peso (ARS) has depreciated a lot.

Inflation in Argentina runs at 114% annual rate. Therefore, higher inflation is only positive for a currency up to one point.

What is that point? When is the line crossed?

That point is when people lose trust that inflation can be contained. When trust in the central bank’s ability to contain inflation is lost, then anchoring inflation expectations becomes virtually impossible.

Sure enough, the UK is not Argentina. But people should not underestimate households and businesses expecting higher prices for longer, as reflected in today’s wage data. This vicious circle is difficult to exit once the trust in the Bank of England is lost.  

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