By Mike Dolan
LONDON (Reuters) – Is it the first country to raise interest rates, the first to hit its inflation target and the last to cut rates?
It may be unwise to read too much into the volatile and marginal bets on interest rates in financial markets, but for now, these bets are shaping the course of the Bank of England’s policy against its major economic peers.
The pound, which is excited by the outcome of this month’s crucial British election, is more receptive to this sequence of interest rates than anything else. This may be one reason why the Bank of England may give in to market temptations next month, even though the chances of that happening are still only 50%.
Sterling topped $1.30 for the first time in a year this week, hit a two-year high against the euro and a 16-year high against the battered Japanese yen. The Bank of England’s trade-weighted sterling index is at its highest level since the 2016 Brexit referendum — up about 13% from its lows in the government’s blatant 2022 budget farce.
Will the sheer power of the pound be enough to force him to act?
The debate over the extent of so-called exchange rate “passthrough” to inflation has raged for many years – with many different views on the underlying conditions that make it effective.
The obvious counterpoint is that the main problem facing the Bank of England at the moment is not so much dollar-denominated import or energy prices as still-high domestic price inflation.
But in the event of a split decision, sterling could push things forward – especially if there is concern that financial conditions in the UK more broadly are not tightening excessively at the wrong time.
UK economic surprises are unusually positive at the moment, but their global counterparts turned negative mid-year, and the exchange rate could play a big role if that signals a broader international slowdown.
First time in last outing
Aside from Japan’s bizarre cycle, the Bank of England was the first of the G7 nations to start raising borrowing costs to the post-pandemic inflation peak in late 2021 — rising twice before the US Federal Reserve took action three months later, raising rates by 5 percentage points to near-zero in 20 months.
Despite continuing to be troubled by annual wage gains and service price growth above 5%, the Bank of England this year became the first of its peers to hit its main 2% inflation target – which it has held for two months now.
But the nervous world of financial markets still expects Germany to be the last of the six banks to implement the first interest rate cut – after not only the European Central Bank and Canada in the Group of Seven, but also the Swiss and Swedish central banks.
Markets believe the European Central Bank, Canada and Sweden are likely to cut interest rates for a second time before Threadneedle Street is ready to back down.
To be sure, the BoE could lag the Fed by just one day in September if its interest-rate bets match those expectations. But even then, there is still little doubt in financial markets that the Fed will make a decision in two months’ time, with futures comfortable with fully pricing in any Fed move.
But why so cautious, and does the UK really need to be on both sides of the global cycle?
knife edge
For decades, Britain was considered an inflationary anomaly – partly because of the instability of the pound and its impact on such an open economy, a poor productivity record, and political control over interest rates until 1997.
The Bank of England’s independence changed the balance of power. But the UK’s overexposure to the 2008 banking collapse, and then to the trade and investment disruptions caused by Brexit, caused the pound to fall in value – even if this decline in domestic prices may have been masked by muted global inflation more broadly.
All this has changed as global inflation has surged after Covid-19 – with annual price increases in the UK exceeding 11% at one point, higher than peak levels in other countries.
The government’s blunders in the 2022 budget have added to perceptions of financial risk and concerns about the Treasury and central bank’s shared thinking on controlling inflation – exacerbating the UK’s vulnerability to a Ukraine-related energy shock.
Some of that has been painfully fixed since then, with many foreign investors seeing this month’s change in government as a clean break.
Now the question is whether the Bank of England can breathe a sigh of relief. For starters, headline inflation expectations fell to their lowest level since before the pandemic this month, which may ease some of the BoE’s concerns about “persistent” wage and services inflation.
Beyond the rise in sterling, the dissipation of the latter risk factor can be seen most clearly in UK government bond markets, where the 150 basis point yield premium on five-year UK government bonds over their German counterparts has fallen by a full percentage point from its level at the peak of the 2022 budget blowout.
But on the flip side, if the BoE’s concern turns to the risks of staying too tight for too long, the sight of a “real” five-year inflation-adjusted gap with Germany at a 20-year high might be food for thought.
With sterling now comfortably benefiting from this premium rather than hesitating to deal with it, the Bank of England may see it as a window.
A month or two may not matter very much in the larger scheme of things, of course.
But despite the hesitant pricing in money markets, there are plenty of economists who still expect the Bank of England to beat the US Federal Reserve – with banks such as Barclays and Deutsche Bank forecasting a rate cut next month, and the central bank using new forecasts in its latest monetary policy report to explain why.
“The central bank’s August rate decision is on a knife edge,” said Gabriella Dickens, G7 economist at AXA Investment Managers, adding that she expected policymakers to vote 5-4 in favour of a cut.
The views expressed here are those of the author, a Reuters columnist.
(By Mike Dolan, @reutersMikeD; Editing by Jamie Freed)
