The pound is vulnerable amidst elevated recession fears ahead of the Bank of England’s (BoE) next policy move on Thursday. The UK central bank is expected to announce its interest rate decision and the pound is struggling to regain its strength as a widely expected interest-rate hike by the BoE will increase recession fears. UK Treasury advisers have warned that an aggressive rate-tightening cycle will hurt the economic outlook.
High inflation requires higher interest rates
UK inflation hit a 41-year high of 11.1% in October 2022 and remained at 8.7% in May, more than double the rate in the United States and much higher than in the Eurozone.
With inflationary pressures being four times higher than the 2% target, the BoE will be forced to raise interest rates further, analysts have stated. Britain’s inflation is among the highest in the G-7 economies due to labour shortages and high food prices. In June, UK headline inflation cooled to 7.9% while the core Consumer Price Index (CPI) (excluding food and oil prices) decelerated slightly to 6.8% from 7.1%.
In July, following criticism over the BoE’s approach to price growth, BoE Governor Andrew Bailey said that regulators and authorities were trying to bring inflation down by tackling retail prices, especially in the fuel market. He also noted that there was evidence that some retailers were overcharging customers.
In an interview with the BBC, Bailey highlighted his previous comments that the BoE must lower inflation or risk more pain from high interest rates in the future. At the same time, higher borrowing costs are weighing on the UK’s housing sector and factory activities, and firms and households are now postponing their credit requirements to avoid higher interests.
How much higher will the BoE raise interest rates?
Investors are uncertain about the pace at which the BoE will raise interest rates. The bank could tighten monetary policy by 50 basis points (bps) to 5.5%—making it their 14th consecutive interest-rate hike.
With the bank’s aggressive rate-tightening cycle, the market expects the pound to come under pressure as recession fears deepen further.
While interest rates are rising, the UK economy has remained optimistic. According to Reuters, UK lenders approved more mortgages in June than expected and unsecured credit increased by the most in more than five years.
Lawmakers have criticised banks for not raising rates on savings at a similar pace at which borrowing rates were elevated. The UK’s Financial Conduct Authority (FCA) required an explanation from commercial banks for not elevating interest rates on household savings.
GBP/USD: Looking ahead this week
Economists at Société Générale expect the pound to remain under pressure ahead of the BoE meeting on Thursday. As they noted, “Suspense around the BoE rate decision on Thursday should keep Sterling on a knife edge with price action before the announcement likely to depend on the US manufacturing ISM data today and ADP employment on Wednesday.”
Meanwhile, market sentiment remains cautious ahead of the United States factory activities and labour market data. US factory activity is anticipated to remain in a contraction phase for its ninth month in a row. Wednesday’s ADP employment data will also attract attention.
Chicago Federal Reserve (Fed) Bank President Austan Goolsbee has supported further policy tightening despite inflation easing.