As Britons come to terms with higher borrowing costs than they have known for 15 years, one or two will be forgiven for asking why the pound is not rallying more strongly in response to the Bank of England’s recent interest rate rises.
Sterling, as any British tourist who has ventured overseas this summer will confirm, remains deeply depressed compared with levels most people will be used to.
The pound was trading at just $1.175 this morning, down from $1.21 in the days immediately after Vladimir Putin invaded Ukraine, while against the euro it has similarly fallen from just under €1.21 to under €1.18 today.
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That may puzzle some people when the Bank of England was the first of the world’s major central banks to begin raising interest rates in the current rate-tightening cycle in December last year – ahead of peers such as the US Federal Reserve, the European Central Bank, the Bank of Canada, the Reserve Bank of Australia, the Reserve Bank of New Zealand and Sweden’s Riksbank.
Conventional wisdom holds that higher interest rates tend to be supportive for a particular currency.
This may be because the Bank has not raised its policy rate as aggressively as the likes of the Fed and others.
However, the pound has also struggled to perform against currencies whose central banks have not raised interest rates as aggressively as the Bank, most obviously the euro and some of the Scandinavian currencies.
A pound currently buys 12.5 Swedish krona, down from 13.25 at the beginning of March, even though the Riksbank’s key policy rate is just 0.75%. It will only buy 8.77 Danish krona, down from nearly 9.1 at the beginning of March, even though the main policy rate of the Danish Nationalsbank currently sits at just -0.1%.
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So something else seems to be going on – and that something is that markets are betting on the UK’s economic outlook being weaker than any other major economy next year.
The foreign exchange market talks in terms of the “G10” major currencies: the US dollar, the euro, the yen, the pound, the Swiss franc, the Australian dollar, the New Zealand dollar, the Canadian dollar, the Swedish krona and the Norwegian krona. Sterling is currently expected to underperform all the other nine during 2023.
It is not just the UK’s lacklustre economic prospects that appear to be hurting. There also appears to be scepticism on the FX markets that the Bank is going to be able to raise interest rates as high as would normally be expected to sufficiently combat inflation for fear of tipping the economy into a recession, or prolonging one.
The Bank is now forecasting that the UK will enter a recession in the final three months of this year, while interest rates are expected to continue rising. This would mean that, next year, the Bank is likely to be raising interest rates during a recession for the first time since 1975.
But former rate setters at the Bank believe the Monetary Policy Committee needs to be thinking about a far higher level of Bank Rate than it has hitherto been prepared to contemplate and particularly if, as investment bank Citi predicted this morning, inflation goes as high as 18.6% next year – higher than anything the Bank itself is forecasting.
Andrew Sentance, who was on the MPC from 2006 to 2011, a period taking in the global financial crisis, wrote in the Times today that Bank Rate will need to go as high as 4% “over the next six to 12 months, perhaps higher”.
Others suggest Bank Rate needs to go higher still. Dame DeAnne Julius, a founding member of the MPC, told the Daily Telegraph last week that Bank Rate would need to go to between 4-5% while Willem Buiter, a fellow MPC member, said they would need to go to 6%.
The question is, though, whether the Bank dare to go that high. And few think that will happen.
As Charles Goodhart, another former MPC member, told the Telegraph: “My guess is that the Bank will stop raising short-term rates slightly above 4%, but that will not be enough to bring inflation back to target, because the damage to output and unemployment will be felt to be too high.”
What else is behind the weak pound?
Adding to sterling’s weakness have been the persistently poor trade figures.
The latest figures from the Office for National Statistics, published earlier this month, revealed that the UK’s total trade in goods and services deficit, excluding trade in precious metals which distorts the figures, widened by £2bn to £27.9bn during the three months to the end of June – making it the largest quarterly deficit since records began being compiled in this way at the beginning of 1997.
This reflected a big drop in exports to non-EU countries and a slightly smaller drop in exports to EU countries.
All of this is weighing on sterling.
It also poses a challenge not only to the Bank but also the incoming prime minister.
Wall Street – until last week – had enjoyed four solid weeks of gains because investors had convinced themselves that the Federal Reserve had, in the jargon, got back “ahead of the curve” on inflation. Investors have been forced to reappraise that thinking after hints from Fed officials that there is still further aggressive tightening to come.
But Andrew Bailey, the Bank’s governor, and his colleagues have yet to convince markets that they mean business on inflation in quite the same way.
So it is perfectly likely that next month’s interest rate rise – and there will be one, the only question is whether the Bank raises by half of 1% or three-quarters of 1% – is accompanied by more tough talk.
Jawboning, in the market vernacular, is one thing. Perhaps the bigger question is whether the incoming PM can talk convincingly of improving the UK’s woeful record on trade, business investment and productivity over the long term.
Pull that off and sterling will respond.
At the moment, it does not seem very likely.
