The British Pound look set for a volatile day ahead as traders brace for what may be a major policy shakeup to be unveiled in the BOE’s quarterly Inflation Report.

Talking Points

• Pound Likely to Fall if BOE Introduces “Forward Guidance” in Inflation Report
• Japanese Yen Outperforms as Nikkei Drops Nearly 3 Percent in Overnight Trade

All eyes are on the Bank of England’s quarterly Inflation Report in European trading hours. The central bank spelled out the significance of the publication in no uncertain terms in July’s policy statement: “[The] Chancellor had requested that the [MPC] provide an assessment, alongside its August Inflation Report, of the case for adopting some form of forward guidance, including the possible use of intermediate thresholds. This analysis would have an important bearing on the Committee’s policy discussions in August.”

The level of speculation surrounding the release has probably grown further after the BOE opted not to introduce forward guidance at the August MPC meeting. On one hand, this may have meant that such a move was ruled to be unnecessary against a backdrop of steady improvement in UK economic news-flow since March. Needless to say, the British Pound is likely to react favorably if the Inflation Report shows this to be true.

On the other hand, the Bank may have preferred to introduce the new policy framework along with a detailed report explaining its reasoning. Such a strategy seems reasonable if policymakers’ objective was to avoid the kind of speculation-driven volatility that followed the Fed’s move to formally introduce “tapering” QE into the policy outlook at the June FOMC meeting. The US central bank spent the following several weeks scrambling to explain itself and tame financial markets, a fate that Mark Carney and company may well have consciously aimed to avoid.

If this is the case, the degree of policy innovation to be unveiled in the Inflation Report is presumably significant. This can take the form of tying the duration of accommodative monetary policy to thresholds expressed in terms of time, specific economic outcomes, or both. Sterling has moved broadly higher along with front-end yields since the August BOE meeting proved to be a non-event, which seems to reflect moderation in dovish policy expectations. The evolution of 12-month policy expectations priced into OIS rates reflects the same dynamic. This means the introduction of forward guidance this time around will probably compel the markets to reposition once again, sending the British Pound lower.

The Japanese Yen outperformed in overnight trade, bolstered by an unwinding of carry trades funded cheaply in terms of the perennially low-yielding currency as risk appetite unraveled. The Nikkei 225 benchmark stock index plunged nearly 3 percent. The move may reflect expectations that the Bank of Japan will opt not to expand stimulus efforts as officials began their two-day policy meeting today.

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--- Written by Ilya Spivak, Currency Strategist for Dailyfx.com

To contact Ilya, e-mail ispivak@dailyfx.com. Follow Ilya on Twitter at @IlyaSpivak

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