Monetary policy and interest rate decisions are crucial tools used by central banks to manage economic stability and growth.
The Bank of England (BoE) plays a pivotal role in setting these policies to control inflation, support employment, and ensure the overall health of the UK economy. This article explores how these critical decisions are influencing the UK economy and the value of the pound sterling, and what this means for private investors.
Inflation Surge and Disinflation Efforts
Like other economic centres, the United Kingdom has experienced a significant rise in inflation over recent years, driven by the pandemic and subsequently by the war in Ukraine. This surge was most pronounced during 2021 and 2022. After reaching a peak, the rate of price increases began to gradually decline. The disinflation process started at the beginning of 2023 and continues to this day. A significant contributor to this trend has been the Bank of England, which, similar to the European Central Bank and the Federal Reserve, embarked on an aggressive cycle of tightening monetary conditions.
Investors should focus on the upcoming inflation report, which will be released in mid-July. Its details may largely determine the BoE's future decisions. If the report does not contain negative surprises (such as an upward revision of CPI forecasts), there might be a chance for action in August. However, if the predictions indicate that elevated inflation will persist in the UK and highlight its "persistence," the chances of a rate cut in August could significantly decrease. The market would then have to adjust its pricing, possibly leading to a strengthening of the pound against major currencies.
Bank of England's key interest rate and measures of headline and core inflation, year-on-year, source: Bloomberg
Market Awaits Possible August Rate Cut, BoE Holds Rates Steady in June
The June decision to keep interest rates unchanged turned out to be in line with market expectations. Seven MPC members voted to maintain the 5.25 per cent level, while only two supported cuts. The statement following the meeting had a slightly dovish tone, leading to a change in the implied probability of the interest rate path in the UK. The market now gives over a 60 per cent chance of a rate cut as early as August, which is twice as much as before the decision.
However, the August cut is not yet certain. The assertion that decisions will be made on a meeting-by-meeting basis, based on the latest macro data, means that investors should closely monitor current publications, especially those related to price growth dynamics. The pound will also be sensitive to other data showing the developing economic situation in the UK. Wage figures will be significant as they currently influence service inflation. Its current elevated level (5.7 per cent) is one of the central bank's "headaches" preventing a lasting reduction in inflation to target levels.
Economic Recovery and High Interest Rates
Maintaining high interest rates is also supported by the argument of a rebounding British economy. The outlook is undoubtedly better than a few months ago. Looking at the real economy, leading indicators such as PMI for services and manufacturing suggest that the UK is gradually emerging from a prolonged period of weakness. Values remain above the critical 50-point level, indicating that economic growth dynamics will increase. The improvement in the first quarter was reflected in hard data. Growth dynamics reached 0.6 per cent quarter-on-quarter, meaning the economy grew at its fastest pace since Q4 2021. Like other European countries, the UK is effectively benefiting from lower natural gas prices. Prices have returned to pre-war and pandemic levels, allowing the economy to normalise.
UK monthly GDP growth, quarter-on-quarter change, source: Bloomberg
PMI indicators for the UK's service and manufacturing sectors, source: Bloomberg
Outlook for the Pound and Monetary Policy
The pound is expected to strengthen against currencies with more expansionary monetary policies. The GBP/JPY pair should continue its upward trend, as the Bank of Japan remains reluctant to tighten further. The pound is also likely to maintain its advantage against the euro, with the ECB's rates peaking lower than the UK's. The EUR/GBP pair should continue its downward trend, having broken a key technical barrier at 0.85.
Against the US dollar, the pound should remain relatively stable, with both the BoE and the Fed being equally restrictive. The market anticipates two rate cuts this year for both, likely in September and December, suggesting a broad consolidation in the GBP/USD pair.
The pound should also gain against the CAD, as Canada's disinflation process progresses smoothly. The BoC lowered rates in June from 5.0 per cent to 4.75 per cent, with further cuts expected in the third and fourth quarters.
Author: Łukasz Zembik, Senior Market Analyst at
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