Bank of England raises interest rates, dovish message sinks Sterling

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More than a decade after its last hike, the Bank of England announced on Thursday afternoon that it would be increasing its benchmark interest rate by 25 basis points back to 0.5%, a little over a year after rates were cut in the immediate aftermath of the Brexit vote.

As we had anticipated prior to today’s meeting, members Ramsden and Cunliffe both voted to hold rates steady, although fellow MPC member Tenreyro somewhat surprisingly supported a hike. The vote was split 7-2 in favour of a rate increase, a slightly more comfortable majority than the 6-3 vote that the market, and indeed ourselves, had anticipated. The committee judged that it was ‘appropriate to tighten modestly the stance of monetary policy in order to return inflation sustainably to target’.

With a hike today almost entirely priced in by the market, currency traders took their cue from the tone of communications in the bank’s meeting minutes, rather than the rate decision itself. The bank adopted a cautious tone with regards to addition policy tightening with all members agreeing that future interest rate hikes would be both ‘at a gradual pace and to a limited extent’. It also said that its economic forecasts were based off just two future interest rate increases over the next three years which would be required in order to prevent the economy from running ‘too hot’. This is a slower pace of hikes than the market had priced in leading up to today’s announcement.

The bank voiced particular concern over Britain’s decision to leave the European Union, claiming that the Brexit process was already having a ‘noticeable impact’ on the economic outlook. It modestly lowered its GDP growth forecast this year to 1.6% from 1.7% amid ‘considerable risks’ that remain, including around the EU negotiations. Carney explicitly stated that Brexit would likely be the biggest driver of interest rates.

Sterling traders reacted negatively to this dovish tone and possibility that rates would remain at their current 0.5% level for a more prolonged period of time than was initially anticipated. The Pound sold-off by almost one percent against the Euro, while crashing back below the 1.31 level against the US Dollar, erasing all of its gains in the week leading up to today’s meeting (Figure 1).


Figure 1: GBP/USD & GBP/EUR (02/11/2017)

Figure_1_GBPUSD_GBPEUR_02112017.png

Source: Thomson Reuters Datastream Date: 02/11/2017

On the topic of inflation, Governor Mark Carney reiterated that price growth was likely to have further overshot its target last month. We have mentioned for a number of months that the Bank of England would likely reach a tipping point in favour of a hike should inflation in the UK accelerate towards the 3% level. Headline inflation did indeed rise to a five year high 3.0% in September (Figure 2) and is expected to have peaked at 3.2% in October. Carney said in his accompanying press conference that some removal of stimulus would be required in order to lower prices back to the bank’s 2% target level, although this is not forecast to happen until 2020.


Figure 2: UK Inflation Rate with forecast (2013 - 2017)

Figure_2_UK_Inflation_Rate_with_forecast_2013-2017.png

Source: Thomson Reuters Datastream Date: 02/11/2017

The Bank of England clearly remains wary of the downside risks posed from Brexit and today’s communications suggests it is still some way off from joining the Federal Reserve in engaging in a full on hiking cycle. We think that another hike later in 2018 is possible, although we would need to see a marked improvement in overall economic growth, a more sustained rebound in the labour market and data that inflation is showing little signs of returning to target.

The prospect of another prolonged period of stable rates in the UK could present a drag on the Pound in the short term. However, with the market still pricing in just about the worst case scenario to Brexit negotiations, we think there remains room for long term Sterling gains against most major currencies. In our view, this appreciation will be faster against the Euro, given the European Central Bank is still some way off from a rate hike of its own.

 

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