Column-Sterling feeds on exceptionally high BoE ‘terminal rate’: Mike Dolan By Reuters

By Mike Dolan

LONDON (Reuters) – Tight monetary policy, coupled with a penny-pinching fiscal agenda, usually leads to currency appreciation, and sterling is rising on the outlook. But it is far from clear why the UK government or the Bank of England want a rising pound right now.

The BoE’s decision this week to delay its second interest rate cut of the year was seen by many central bank watchers as an expected “non-event”.

But the freeze is more significant – and even a bit eye-catching – given what the BoE’s G7 peers are doing – not least the Federal Reserve’s huge half-point rate cut the previous day and the Bank’s second rate cut European Central from 2024 last week.

Keeping the UK policy rate at 5% may simply be a matter of messaging, as the BoE seemed to suggest.

It could be a signal to wage negotiators that they need to lower their expectations and a call to service sector firms to reduce still high price increases. Or it may just be reasonable hesitation as the BoE waits for the hard data it will get in the new Labor government’s first budget, which is due to be published next month.

But with the BoE’s repeated stress on removing the “persistence” of inflation, a much louder tone was needed than other major central banks have taken recently – so much so that markets now believe the chance of a BoE cut in November is below 70%, in comparison. to a certain thing before the meeting.

And where markets see the UK’s easing cycle ending is just as stark.

The default “terminal rate” is currently around 3.4%, which the central bank is expected to reach by the end of next year. This is nearly 50 basis points higher than the equivalent Fed rate, 150 bps above the ECB and Bank of Canada and 300 bps above the Bank of Japan.

These policy rate premiums are all higher than they were in the decade before the global 2022 tightening scramble.

It is not entirely clear what justifies this. Are inflationary pressures in the UK today any worse than those in other major economies? Has the UK’s historical vulnerability to inflation resurfaced? Or has Brexit thrown a spanner in the works in the meantime?

The market’s long-term rate horizon also looks puzzling when considering other details of the central bank’s outlook.

In its meeting statement, the BoE downgraded its GDP growth forecast for the current quarter, said services inflation would fall further by the end of the year and noted that surveys showed public inflation expectations falling again to pre-pandemic levels as headline inflation overshoots its target. 2%

Economic difficulties should be greater if the next government budget is true to early indications and tightens fiscal policy with a combination of tax increases and spending cuts needed to plug a £20bn (£26.55bn) hole dollars) in public finances.

STERLING STARING

Sterling seems to like it. The promise of relatively tight monetary and fiscal policy pushed sterling to its highest level against the dollar in two years. And it’s a whisker away from its two-year highs against the euro.

The trade-weighted Sterling Index is up more than 3% this year alone and is within a stone’s throw of its highest point since the 2016 Brexit referendum.

With trade-related Brexit issues at least part of Britain’s growth problem, a rising pound can hardly be all that helpful at the moment.

Even if a strong pound puts downward pressure on imported energy or commodity inflation, that hardly helps the BoE. His stated concern is domestic services and wages, which are largely unrelated to the exchange rate.

The BoE noted that the pound’s effective exchange rate had appreciated by more than 1% since its previous meeting, although it blamed changes in the US rate and the move in the dollar for most of it.

“IDIOSYNCRATIC”

If it’s all just a matter of time, then the BoE will have to accelerate its easing, and some economists believe it will.

“If the government is more stringent on fiscal policy, we believe the Bank will be forced to increase the pace of the tightening cycle to offset the impact on both household and business finances,” said AXA Investment Managers economist Gabriella Dickens, adding that there was an outside chance of two cuts by the end of the year.

And the central bank could find itself with some considerable catching up to do.

Jefferies economist Modupe Adegbembo said that while there could be “idiosyncratic” reasons for the persistence of UK inflation, pressure on the BoE to deliver two more cuts this year would increase significantly if the Fed were to cut another 50 bps at his next meeting.

So sterling may have good reason to be where it is now – but that strength could evaporate quickly if it relies solely on such a large BoE landing zone.

The opinions expressed here are those of the author, columnist at Reuters

($1 = £0.7534)

(By Mike Dolan; Editing by Jamie Freed)