Analysis – Weak pound and forceful Fed pressure Bank of England to act big

By Andy Bruce

LONDON (Reuters) – With Britain’s currency sinking and the U.S. Federal Reserve poised to raise borrowing costs aggressively, Bank of England policymakers may suddenly feel pressured to announce an outsized interest rate hike of their own this week.

Even though Britain’s economy shrank unexpectedly in April and there were some signs of inflationary forces in the labour market ebbing, the pound’s slide and the increasingly hawkish stance of other central banks put the BoE in a tough spot.

All but one of the 56 economists polled by Reuters last week expected the BoE to raise Bank Rate on Thursday to 1.25% from 1.0%, but many warn a rise to 1.5% could be a close call. [ECILT/GB]

Financial markets point to a roughly 43% chance of a 50 bps hike.

Recent events arguably show why.

Sterling on Tuesday slid below $1.21, its lowest since May 2020 – a headache for members of the Monetary Policy Committee who know that a weak currency will exacerbate inflation in the months ahead, with Britain reliant on energy imports.

The pound has fallen 4.5% against the dollar since late May, when finance minister Rishi Sunak announced further help for households facing a hefty cost-of-living hit – a package that economists had thought might shore up confidence in Britain’s economic outlook, and with it the currency.

The boost to sterling did not last long, however, as U.S. inflation accelerated more than expected, intensifying bets on Fed rate hikes.

Last week, the European Central Bank flagged rate hikes at its next two meetings, including a possible half percentage-point rise in September.

The BoE’s trade-weighted sterling index, which measures the pound against a basket of currencies, fell on Monday to its lowest since January last year.

HAWKISH CENTRAL BANKS

Brexit tensions – namely the escalating row over Northern Ireland’s status that threatens to upend British trade ties with the European Union – have also hurt the pound.

Worse yet could follow if, as financial markets increasingly expect, the Fed on Wednesday raises its main interest rate by 75 basis points, which would be its biggest increase since 1994, further boosting the dollar at sterling’s expense.

The central banks of India and Australia have already raised rates by 50 basis points, the latter coming as a hawkish surprise to investors.

“If the Bank starts to lag behind, then that would probably increase the downward pressure on the pound,” said Paul Dales, chief UK economist at Capital Economics.

“That would actually influence the Bank of England’s projections for its inflation target in three to four years time, which is what it’s aiming for,” he added.

Dales was the only economist in the Reuters poll to forecast a 50 basis-point increase in Bank Rate.

Previous BoE research has suggested a 10% fall in sterling would raise the level of the consumer price index by about 2.7 percentage points, over a period of three to four years.

REASONS NOT TO HIKE

But some economists say the BoE should resist pressure to join other central banks in a rush to raise rates, given Britain looks more prone to recession than many of its peers.

The OECD sees zero British growth next year – the weakest of any G20 economy apart from Russia – and the British Chamber of Commerce expects the economy to shrink 0.2% in the final quarter of 2022 before growing just 0.6% in 2023 and 1.2% in 2024.

“What you wouldn’t want to see is the MPC losing its independence of thought and joining a big cohort of central banks in a stampede to tighten aggressively,” said Philip Shaw, chief economist at Investec.

A 50 basis-point hike – which would be the first in Britain since February 1995 – would represent a presentational challenge for the BoE. Its chief economist Huw Pill has stressed the virtues of a “steady-handed”, gradual approach to raising rates.

The BoE was the first of the world’s major central banks to raise rates in December last year and another hike on Thursday would be the fifth time in five policy meetings that it had increased borrowing costs, its steepest pace in 25 years.

Also there remains a question over whether five or more of the nine MPC members would plump for such a big rate hike.

In May, only three external members – Jonathan Haskel, Michael Saunders and Catherine Mann – voted for a 50 basis-points hike.

Even if they were joined on Thursday by Deputy Governor Dave Ramsden, who has previously sat on the hawkish end of the MPC, they would still need at least one more of the other members – none of whom have publicly expressed an appetite for moving in bigger steps.

Economists from Bank of America on Tuesday said their base case was for a 6-3 split in favour of a 25 basis-point hike.

“We see risks skewed to a 5-4 vote and look for more hawkish guidance,” they added.

All BoE watchers are agreed, however, that the swirl of downbeat data, febrile financial markets and political pressure make predicting policy especially tricky.

“It’s quite easy for me to come out and say, ‘go on, do this’ but they have to make a decision that really makes a difference,” Dales from Capital Economics said. “They have my sympathy.”

(Reporting by Andy Bruce; Editing by Alex Richardson)