Fate of British pound firmly in hands of central bank

The British pound is recovering from the blow the currency received after an interest rate cut in early August. Currency markets expect the Bank of England (BoE) to temporarily hold off. Or is chairman Andrew Bailey secretly preparing for an interest rate cut?

The United Kingdom has had a good summer economically. In mid-July, the British statistics office announced that the economy had grown at the fastest pace in over two years in the previous three months. In May alone, the economy expanded by 0.4%, double the economists' expectations. This positive surprise led several investment banks to raise their expected growth rate for the whole of 2024 from around 1% to 1.5% or more. Prime Minister Keir Starmer even promised that economic growth could eventually reach the 2.5% mark of the early 2000s.

Boosting economic growth
Starmer took office this summer after his Labour Party's resounding victory in the July 4 elections. He plans to relax strict rules for home builders and provide targeted investments in infrastructure to give growth sectors an extra push. Starmer also hopes that Labour can attract foreign investors to invest in the UK by offering a more predictable policy than the Conservatives. The Conservative government was marked by chaotic Brexit negotiations and a trial budget by former Prime Minister Liz Truss that caused major turmoil in financial markets.

Sharp exchange rate movement
In practice, the Bank of England's policy has as much influence on the economy as Starmer's measures. A few days after the economic growth figures were released, the pound reached its highest level against the euro in over two years. However, in early August, the currency took a step back by over 2%. This sharp exchange rate movement of the year followed the central bank's decision to cut the policy rate by 25 basis points to 5%. BoE Chairman Andrew Bailey also hinted that the rate could decrease faster in the future than what currency markets had anticipated.

Temporary hold off
During a speech last Friday, Bailey mentioned that inflation is clearly decreasing. He noted that it is still too early to completely extinguish the signal. Currency traders saw this as an indication that the BoE will not further reduce the policy rate in September. On the other hand, a rate cut by the European Central Bank in that month is almost certain. The growing interest rate differential makes it more attractive for parties to hold assets in pounds. This explains why the currency rebounded in August after the initial shock of the rate cut. However, an inflation rate of 2.2% does give the BoE room for a rate move. If that happens, currency markets will be completely caught off guard.

Joost Derks

Joost Derks is a currency specialist at iBanFirst with over twenty years of experience in the foreign exchange market. This column reflects his personal opinion and is not intended as professional (investment) advice.

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