Will the Bank of England strengthen sterling with another rate rise?
Pound sterling is set for a tumultuous February as the Bank of England prepares to hike interest rates in the face of rising inflation and an energy-induced cost-of-living crisis.
Pound sterling is now in recovery mode as markets worldwide move to consolidate recent heavy losses. But with 52% of IG clients currently long on the GBP/USD major currency pair, more volatility appears inevitable.
Pound sterling: inflation and interest rates
With Consumer Prices Index (CPI) inflation at a 40-year high of 5.4%, the Bank of England is under intense pressure to raise the UK’s base rate from its current 0.25%.
But the Bank expects inflation to hit 6% in April, and then to cool off thereafter. And it surprised investors in November, declining to raise the base rate, only to increase it a month later. But internal government estimates indicate that CPI inflation could soon hit 7.1%, while Goldman Sachs believes 6.8% is plausible unless the government takes action to curb energy bills. And with Monetary Policy Committee member Catherine Mann believing that the Bank should ‘lean against’ entrenched inflation, a rise seems more likely than not.
Moreover, ING analyst James Smith believes ‘inflation has surprised higher, again, and that's only likely to increase the temptation for Bank of England policymakers to hike rates.’ And Samuel Tombs, Chief Economist at Pantheon Macroeconomics thinks ‘they need to do something in the short term to reinforce their credibility, anchor inflation expectations, and perhaps support sterling as well.’
But the truth is that the inflation surge is being driven by rising energy prices, which are unlikely to be impacted by a domestic rate increase. According to Energy UK, the average annual UK household bill will rise by £500 in April. And while government leaks suggest a £500 one-off payment for poorer households might be in the works, Bank Governor Andrew Bailey believes energy prices will remain elevated until mid-2023. Moreover, the Bank of America is predicting Brent Crude could hit $120 within the next few months.
And the bank also has the unenviable task of balancing interest rate rises with public sector debt affordability. The government borrowed almost £17 billion in December, while debt interest payments rose to £8.1 billion, up from £2.7 billion the year before. And much of this rise is attributed to the quarter of public debt linked to Retail Price Index inflation, currently at 7%. On the other hand, every 1% base rate increase adds £20 billion to the cost of public debt repayments.
Meanwhile, Chancellor Rishi Sunak is under pressure to scrap April’s National Insurance increase of 1.25 percentage points, with MP David Davis publicly stating that the government didn’t know ‘the pressure there would be on ordinary people.’ Capital Economics believes there is enough ‘fiscal room to cancel’ the rise, while the Institute for Fiscal studies suggests a delay is financially feasible. But Sunak argues that it’s ‘important that we avoid burdening future generations with high debt repayments.’
And with rate rises often taking months to feed into the economy, the government could find itself with sky-high interest payments on public debt, whilst the public is hit with rising inflation, rates and taxes.
Nord Stream 2 and Ukraine
Moreover, the energy crisis is set to escalate due to the geopolitical tensions caused by the Ukraine crisis. Western powers have agreed ‘allies must enact swift retributive responses including an unprecedented package of sanctions’ if Russia invades, with PM Boris Johnson saying there is ‘gloomy’ intelligence that Russia is planning a lightning raid on Kyiv.
However, about a third of the EU’s gas comes from Russian state energy supplier, Gazprom. Significantly, Russia has already built the Nord Stream 2 export pipeline, which leads directly to Germany, bypassing Ukraine.
The US, Ukraine and Poland opposed the pipeline as it could give even more control of European energy to Russia. UK Foreign Secretary Liz Truss has urged NATO to block the pipeline, warning that it will allow Moscow to exploit European nations for their energy reliance. The political dilemma is that Russia now has the power to either worsen or alleviate the energy crisis across Europe. And this has obvious implications for the value of pound sterling.
In one bright spot, the UK and India have just formally launched free trade talks, targeting a deal by the end of the year. Trade minister Anne-Marie Trevelyan believes it is an ‘opportunity that we must seize to steer our partnership along the track of mutual prosperity for the decades to come.’ The deal could double British exports to India, and boost trade by £28 billion per year.
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