Bank of England faces crucial policy decision with pound at multi-decade low

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Bank of England Governor Andrew Bailey reiterated his commitment to controlling inflation, but the Bank faces a difficult balancing act as growth slows and the labor market tightens.

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LONDON — The Bank of England faces a crucial choice as it navigates a plummeting currency and the effects of a new government package on energy costs that has altered the outlook for inflation.

The monetary policy committee will announce its latest decision on Thursday, with analysts divided on whether to expect an interest rate hike of 50 or 75 basis points.

Headline inflation in the UK fell to 9.9% in August, according to first estimates from the Office for National Statistics, from 10.1% in July, driven by a drop in fuel prices.

But economists were skeptical whether this signaled inflation had peaked, and are awaiting details next week on a new government tax package, which will include a cap on household energy bills.

At its previous meeting, the Bank of England forecast inflation to reach 13.3% by the end of this year, with companies like Citi and Goldman Sachs forecasting extremely high consumer price indices at the start. next year.

Much has changed since then. The Bank’s inflation projections are likely to be revised down in light of the government’s announcement of measures by new Prime Minister Liz Truss.

Still, the additional government support could potentially lead to higher medium-term inflation, economists warned, as the MPC also navigates sluggish growth and an extremely tight labor market.

Other central banks around the world have acted aggressively to bring down inflation. On Tuesday, Sweden’s Riksbank raised interest rates by 100 basis points, warning that inflation was “undermining household purchasing power”.

The US Federal Reserve is expected to raise its benchmark borrowing rate by 75 basis points on Wednesday, the third consecutive hike of this magnitude.

Markets expect the Fed to maintain its hawkish course until inflation is brought under control, which will provide further momentum to the US dollar as investors seek a safe haven in a rising rate environment.

Meanwhile, the European Central Bank earlier this month announced a 75 basis point increase in its benchmark deposit rate.

The pound hit a new 37-year low against the dollar last week amid fears for the health of the economy as the cost of living crisis begins to weigh on activity.

‘Let’s protect our eyes’ for the pound

The Bank rose 50 basis points last month, its biggest increase since 1995, but some analysts say it will need to raise the bar and keep pace with its global peers to avoid a currency sell-off.

“If the Bank of England fails to rise 75 basis points, let’s shield our eyes from what’s going to happen to the pound here,” John Hardy, head of foreign exchange strategy at Saxo Bank, told CNBC on Tuesday.

“The Bank of England needs to go to 75, it needs to match its global peers here when we saw the cable [pound-dollar] trading at its lowest level since 1985. It really would be quite a muted performance from the Bank of England if it didn’t aim for 75 basis points at this week’s meeting.

His thoughts were echoed in a note on Friday by Deutsche Bank’s global co-head of FX research George Saravelos, who said investors should avoid currencies with “very negative real yields” in a world of “destruction of the real and nominal value of the assets”.

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“So it should come as no surprise that the GBP and JPY hit fresh multi-decade lows this week. By extension, next week’s Bank of Japan and Bank of England meetings need to be are currency-critical: a hawkish turn is needed to help protect both,” Saravelos said.

Deutsche Bank has previously warned that the pound sterling in particular is exposed to a potential balance of payments crisis, and Saravelos reiterated that the pound is “vulnerable to extreme dislocation unless the Bank of England steps up its response.” .

The energy price freeze is a game-changer

MPC hawks will no doubt be concerned about recent sterling weakness, but some analysts have suggested that in light of the government’s energy package and increasingly bleak economic data, the Bank is more likely to opt for a gradual tightening message.

Barclays has called the price freeze a ‘game changer’ and now believes inflation may have already peaked and the direct impact of the energy price cap will reduce annual price increases to the consumer. consumption from an average of 9.5% in 2023 to just 5%. Barclays analysts said the pressure on households would now be “substantial but not insurmountable”.

The British lender does not expect the MPC to acknowledge the full effects of the new measures this week, but sees Thursday as a “transition meeting” before the Bank updates its forecast and resets its narrative.

“Consistent with weaker data, we expect dovish dissenting voices to become stronger following the energy price freeze announcement. This would require more gradual tightening, if at all,” it said on Friday. the British chief economist of Barclays, Fabrice Montagne.

Barclays expects a 50bps hike on Thursday with a further 25bps in November and a change in tone once full details of the government’s new policy measures have been set out and macroeconomic forecasts released. updated accordingly.

“Close meeting to call”

Thursday’s meeting is likely to give an indication of the MPC’s concern over the fall in the pound and domestic markets, and how it expects the government’s measures to affect policy. monetary.

ING’s developed markets economist James Smith said it would be a “tight meeting to call” but noted the Bank of England was on form not following the Fed’s lead, after rose 25 basis points in July after the Fed’s 75-point hike.

Although labor shortages may fuel fears of more persistent inflation in the form of higher wage growth, and subsequently more central bank tightening at a later date , Smith argued that this should not manifest itself in a “drastically higher policy rate.”

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“The swap market is pricing a terminal rate in the range of 4.5% next year. A 75 basis point increase is likely to add even more fuel to the fire, which we suspect the committee will be wary of doing, even though there are benefits to preloading hikes,” he added.

ING narrowly favors a 50 basis point hike on Thursday, taking the Bank Rate to 2.25%, but Smith noted that at least a few MPC members will likely vote for 75 basis points.

“We may even get a rare three-way vote – the first since 2008 – if dovish committee member Silvana Tenreyro votes for a 25 basis point hike like she did in August,” he said. he declared.

“If our call is correct, then we expect another 50bps move in November and at least another 25bps in December.”

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