The UK is facing some strong headwinds in 2011 according to the Confederation of British Industry (CBI) which put out a report in which they raised their outlook for inflation and unemployment, while lowering their forecasts for growth. The CBI is the UK's biggest business lobby.

Higher inflation would mean more interest rate increases from the Bank of England which would help the strength of the GBP, but higher unemployment and weaker growth works in the opposite direction.

Let's look at the details of the report:

Here's a link to the official report.

On the topic of inflation, the CBI sees annual inflation averaging 3.9% in 2011, about double the target rate. It had seen an average of 3.3% back in December. Currently inflation is running at a 3.7% clip for the December period. In January, food price inflation hit its fastest pace in 19 months - another indicator of price pressures facing the economy. There will also be upward pressure from an increase in the VAT tax last month.

The recent inflation data has put extreme pressure on the Bank of England to move on interest rates, and we see that in the last Bank of England Minutes we had 2 members voting for a rate increase. The CBI expects the Bank of England to begin lifting interest rates in the second quarter and expected rates to be at 1.25% by the end of the year. It would then reach 2.75% by the 4th quarter of 2012.

On the growth front, the CBI forecast growth to be 1.8% in 2011 and 2.3% in 2012, which is a weaker growth rate than expected by the UK's Office for Budget Responsibility which sees growth at 2.1% and 2.6%.

The CBI also expects unemployment to 8.4% from 7.9% as the country's private sector job growth will be swamped with the public sector job cuts.

Implications for the GBP/USD

Therefore, higher inflation and higher interest rates can help boost the GBP in the short to medium term, but it will come in a weak growth environment that can pressure the GBP in the medium to long term.

The heightened expectations around the Bank of England moving on interest rates because of the higher inflation helped bring the GBP/USD pair to its highest level since early November (prior to the Ireland debt crisis).

width=479

However since touching the 1.63 area the pair has eased off those levels, as the prospect of a weaker economy mean the sharp gains we have seen to be consolidated. Today, we see the pair extending its recent decline.

Most market participants don't see the any move by the BOE tomorrow, but how much longer can they hold out before having to tackle the inflation issue? This CBI report paints the difficulty the BOE faces - weaker growth and higher unemployment with higher inflation - more starkly.

It's going to be a difficult 2011 for the BOE and should lead to increase in volatility in the pair.