By Mike Dolan
LONDON (Reuters) – Tight monetary policy combined with an austerity fiscal agenda usually leads to a stronger currency, and the pound is rallying in anticipation of that. But it’s not at all clear why the UK government or the Bank of England wants the pound to appreciate at the moment.
Many central bank watchers viewed the Bank of England’s decision this week to delay a second interest rate cut this year as a “non-event” expected.
But the freeze is more significant — and even a little puzzling — given what the BoE’s G7 counterparts are doing — not least the Fed’s massive half-percentage-point rate cut the day before and the European Central Bank’s second rate cut in 2024 last week.
Keeping UK interest rates at 5% may just be a matter of sending messages, the Bank of England seems to be suggesting.
This could be a signal to wage negotiators to temper their expectations and a call to service sector companies to rein in still-high price rises. Or it could be just reasonable hesitation as the Bank of England awaits concrete data from the new Labour government’s first budget, due next month.
But with the BoE repeatedly emphasizing the need to eliminate “persistent” inflation, it has taken a distinctly more hawkish tone than other major central banks of late – to the point that markets now believe there is a lower 70% chance of a BoE rate cut in November, compared with the certainty before the meeting.
Markets see the end of the UK’s easing cycle as equally harsh.
The current assumed “final rate” is about 3.4%, which the central bank is expected to reach by the end of next year. That’s about 50 basis points above the Fed’s benchmark rate, 150 basis points above the ECB and Bank of Canada rates, and 300 basis points above the Bank of Japan’s benchmark rate.
These interest rate premiums are much higher than they were in the decade leading up to the global rush to tighten monetary policy in 2022.
But it is not entirely clear what justifies this. Are the UK’s underlying inflationary pressures today really worse than those facing other major economies? Have the UK’s historical weaknesses in the face of inflation resurfaced? Or has Brexit cast a shadow over the situation in the meantime?
The longer-term interest rate horizon in the market also looks puzzling when looking at other details about the central bank’s forecast.
In its meeting statement, the Bank of England cut its GDP growth forecast for the current quarter, said services inflation would ease further by the end of the year, and noted that surveys show headline inflation expectations are falling back to pre-pandemic levels with headline inflation above its 2% target.
The economic burden is expected to be greater if the next government budget is in line with early indications and tightens fiscal policy with a mix of tax rises and spending cuts needed to plug a £20 billion ($26.55 billion) gap in the public finances.
Sterling Championship
The pound seems to be enjoying this. The promise of tighter monetary and fiscal policy has pushed it to its highest level against the dollar in more than two years. It is now just one step away from its highest level in two years against the euro.
The trade-weighted sterling index has risen more than 3% this year alone, and is within a stone’s throw of its highest point since the 2016 Brexit referendum.
Since Brexit’s trade-related problems are at least part of the UK’s growth problem, a stronger pound can’t be of any help at the moment.
Even if a strong pound puts downward pressure on inflation in imported energy or commodities, that doesn’t help the Bank of England much, since its stated interest is in domestic services and wages, which have little to do with the exchange rate.
The Bank of England noted that the effective exchange rate of sterling had risen by more than 1% since its previous meeting, although it blamed much of that on interest rate shifts in the United States and related dollar moves.
“individual character”
If it is all just a matter of timing, the Bank of England will eventually have to accelerate the pace of monetary policy easing, and some economists believe it will.
“If the government is more hawkish on fiscal policy, we think the central bank will have to increase the pace of the cutting cycle to offset the hit to household and corporate finances,” said Gabriella Dickens, an economist at AXA Investment Managers, adding that there was an outside chance of two cuts by the end of the year.
The central bank may find itself having to make great efforts to make up for what it has missed.
While there are “odd” reasons for UK inflation to persist, pressure on the Bank of England to deliver two more cuts this year will rise significantly if the Fed decides to ease interest rates by another 50 basis points at its next meeting, said Modupe Adegbembo, an economist at Jefferies.
So sterling may have good reason to be where it is now – but that strength could quickly evaporate if it relies solely on a high BoE bearish zone.
The views expressed here are those of the author, a Reuters columnist.
(1 dollar = 0.7534 pounds)
(Written by Mike Dolan; Editing by Jamie Freed)
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