These crosscurrents have put the Bank of England in a difficult position: the Bank of England took emergency action this week with a bond buying program to calm the UK bond market, despite politicians intending to start cutting the size of the central bank’s balance sheet to reduce economic stimulus and curb inflation . The International Monetary Fund said it is closely monitoring the government’s budget plans and that it is not recommending large spending programs given concerns about inflation in many countries.
To curb inflation, the Bank of England is likely to raise its benchmark interest rate to 5%, more than double the current official rate of 2.25%, in the coming months, according to Michael Cahill, a foreign exchange specialist at Goldman Sachs Research. The expert answered questions about the fall of the British currency, the monetary policy of the Bank of England and its expectations regarding the UK economy.
What is causing the fall of the British pound?
The UK economy has experienced a significant negative external shock from rising energy prices which is putting pressure on growth prospects as a large share of income is spent on electricity bills – a so-called 'living standard’ shock.
More recently, government plans to help reduce some of these costs and support economic growth have contributed to the pound’s fall. The plan is likely to raise underlying inflationary pressures and increase public debt – at least in the short term – with higher income households benefiting the most. This leads to some difficult trade-offs for the Bank of England, which has already struggled to bring down inflation without causing too much additional suffering to consumers.
Markets expect monetary policy to tighten somewhat in response to the new fiscal measures, but not enough to completely offset these effects. Given these factors together, markets are calling for a higher premium on UK assets due to a cheaper currency and lower government debt prices.
What reaction do you expect from the Bank of England?
While a significant rate hike at the next scheduled meeting is possible, especially if market turbulence picks up, we think further hawkish comments from the Bank of England and major moves at the November meeting are more likely, allowing the Monetary Policy Committee to switch financial news in your forecasts. Given firmer inflationary pressures following last week’s financial announcements and the depreciation of the pound, we expect the BoE to raise rates by 100 basis points in November and December, with a 5% final rate.
Given heightened uncertainty both about the strength of underlying factors and the direction of fiscal and monetary policy, we see bilateral risks to our baseline outlook. Further upward pressure on energy prices, coupled with a lack of business support over the next six months or continued unfunded fiscal support aimed at wealthier households that have a lower marginal propensity to consume, and an aggressive Bank of England rate hike cycle could lead to more sharp recession in the UK.
On the other hand, lower energy prices driven by lower wholesale energy prices and prudent fiscal policy will reduce pressure on the Bank of England to raise rates aggressively. This could ease the pressure on household incomes by lowering electricity and mortgage payments. In this scenario, it is possible that the recession in the UK will be very mild and short-lived, with economic growth rebounding strongly in 2023.
What factors do you follow to understand how the pound is doing?
Given the broad strength of the dollar, it is also important to pay attention to the relative performance of the pound sterling against other major trading partners such as the euro. In addition, the UK’s status as a small open economy means it’s normal for the pound to underperform when global risk sentiment is weak, so we’re looking at how it performs against those factors. Finally, it is especially important to keep an eye on how the British pound behaves in relation to other domestic financial assets.
Most of the time in advanced economies, currencies tend to appreciate when bond yields rise. More recently, the pound has been falling despite sharply higher bond yields, which is usually a sign that markets are worried about policy credibility and therefore could be an important sign for policy makers.