By Mike Dolan
LONDON (Reuters) -First with an increase, first with reaching the inflation target – and last with cuts?
It may be unwise to look too closely at the volatile and marginal interest rate expectations in the financial markets, but for now this is how they outline the Bank of England’s (BoE) policy trajectory relative to its peers in the big economy.
The pound – enthusiastic about the expected but decisive British election result this month – mainly follows that course. And that may be one of the reasons why the BoE may be tempted to jump into the market next month, even though there is still only a 50% chance that it will end up on the money curve.
Sterling hit the $1.30 mark this week for the first time in a year, hitting a two-year high against the euro and notching a 16-year high against the ailing Japanese yen. The BoE’s own trade-weighted sterling index is at its highest level since the 2016 Brexit referendum and is up some 13% from the low of 2022’s shocking government budget farce.
Could the sheer power of the pound be enough to force his hand?
The debate over the extent of the so-called “exchange rate pass-through” to inflation has been raging for years – with many differing opinions on the underlying conditions that make this impact.
The obvious counterpoint is that the BoE’s biggest problem at the moment has less to do with import prices or dollar-denominated energy than with still-sharp domestic price inflation.
But in a split decision, the pound could give things a boost – not least if there are concerns that financial conditions in Britain more broadly do not become too tight at the wrong time.
UK economic surprises are unusually positive at the moment, but global counterparts have deteriorated mid-year and the exchange rate could come into play if that portends a wider international slowdown.
FIRST IN, LAST OUT
Japan’s peculiar cycle aside, the BoE was the first of the rest of the G7 to start raising borrowing costs in late 2021 in response to the post-pandemic inflation spike – raising twice before the US Federal Reserve started three months later and 5 percentage points accumulated to almost zero interest rates in twenty months.
While the BoE continues to chafe at annual wage increases and service price growth above 5%, this year the BoE became the first of its peer group to achieve its 2% inflation target, which it has been working on for two months now. holds.
And yet the nervous world of money markets still expects that it will be the last of the six to make its first cut – after not only the European Central Bank (ECB) and Canada in the G7, but also the Swiss and Swedish central banks.
In fact, markets are betting that the ECB, Canada and Sweden will likely make a second cut before Threadneedle Street is ready to budge.
To be fair, the BoE will only be one day behind the Fed in September if it matches these interest rate expectations. But even then, there is still marginal doubt in the money markets that this one will pull the trigger in two months, while futures can fully price a Fed move.
Why the caution, and should Britain really support both sides of the global cycle?
KNIFE EDGE
For decades, Britain was seen as an inflation outlier, partly due to the instability of sterling and its effect on such an open economy, poor productivity performance and political control over interest rates until 1997.
The BoE’s independence has changed course. But Britain’s excessive exposure to the 2008 banking crisis and then to the disruption to trade and investment caused by Brexit has hit the pound hard – even if that was likely masked in domestic prices by subdued global inflation in in general.
That all changed with the post-COVID global inflation surge – and annual price increases in Britain exceeded 11% at one point, higher than peaks in other countries.
The missteps in the 2022 government budget have heightened perceptions of fiscal risks and fears about joint thinking between the Treasury and the central bank on inflation control, further increasing Britain’s vulnerability to the Ukraine-related energy shock.
Some of that has since recovered painfully, with this month’s change of government seen as a clear breakthrough by many foreign investors.
The question now is whether the BoE can breathe easier. For starters, public inflation expectations fell to their lowest level since before the pandemic this month, potentially easing some BoE concerns about “persistent” wage and services inflation.
Apart from the sterling rally, the disappearance of this latest risk factor can be most clearly observed in the UK government bond markets, where the 150 basis point yield premium on five-year government bonds over German equivalents is a full percentage point lower than at the height of the crisis . the 2022 budget crisis.
But on the other hand, if the BoE’s concerns shift to the dangers of staying too tight for too long, the sight of a five-year inflation-adjusted ‘real’ gap with Germany, at its highest level in twenty years, can provide food for thought.
With the pound comfortably feeding off that premium rather than resisting it, the BoE could see it as a window.
Of course, a month or two doesn’t really matter in the grand scheme of things.
But despite faltering money market prices, there are plenty of economists who still expect the BoE to beat the Fed – with the likes of Barclays and Deutsche Bank set to cut rates next month as the central bank makes use of new forecasts in its latest Monetary Bank. Policy report to explain.
“The August bank rate call is at a razor’s edge,” said Gabriella Dickens, G7 economist at AXA Investment Managers, adding that she expects policymakers to vote 5-4.
The opinions expressed here are those of the author, a columnist for Reuters.
(By Mike Dolan
