The Pound Gains As Inflation Risks Strike a Blow for Monetary Policy Normalisation

This saw the Bank continue along its well-established path of one small rate cut per quarter, a path it has been on since August 2024. Yet today’s Monetary Policy meeting has ended up providing a sharp boost for the pound, which was up approximately 0.7% against the euro and 0.5% against the dollar in the immediate aftermath of the announcement. What gives?

The Bank of England is More Starkly Divided between the Hawks and Doves than Ever

It was the unexpectedly narrow vote to cut interest rates that did it. At the last rate cut in May the Bank was split 2-5-2 in favour of cutting by 50bps, by 25bps, and for staying on hold, respectively. This time round, however, the breakdown was 1-4-4, necessitating an unprecedented second vote to form a majority narrowly in favour of cutting rates by 25bps, as the single voter for a more aggressive 50bps cut moderated their position. The Bank was decidedly more on the fence than expected for what was set to be a routine vote to cut rates once more.

Heighted Inflation Risks Appear to be a Uniquely British Phenomenon

Combined with the more vocal concerns about upside risks to inflation in both the Quarterly Monetary Policy Report and the subsequent press conference, markets rationally concluded that future rate cuts are now no longer a given. Indeed, the Bank has pushed out the date it expects inflation to finally converge back to its 2% target by another quarter, all the way out to Q2 2027. If the Bank’s own economists don’t see inflation returning to target anytime soon, then it is going to be hard to justify ongoing and regular cuts to interest rates, even at the glacial pace it has been doing so since last August.

How Have We Got Here?

One of the most troubling aspects for the Bank of England is that the current drivers of inflation, namely higher food and energy costs, are so visible to consumers that inflation could become entrenched amid the higher wage demands that will inevitably follow. This stickiness will make it difficult to achieve the ‘last mile’ of inflation reduction necessary to allow the Bank to shift its focus to supporting economic growth via interest rate cuts.

The Difference to the Situations in America and Europe

Last month markets mistook the ECB’s and the Fed’s obfuscation on the timing of additional interest rate cuts for hawkish policy shifts, rather than merely a means to keep options open in a highly uncertain economic environment. Yet today’s explicit acknowledgement of upside inflation risks and a material shift in voting patterns at the Bank of England provide a much stronger suggestion that we are indeed on a different policy path than previously thought, justifying the recent bump the pound has enjoyed.

The only sop provided to investors still clamouring for further rate cuts was that, in an unusually muddled answer, the Bank’s Governor Andrew Bailey still conceded that the path for interest rates remains on a downward trajectory, even if he declined to be drawn in to timings and the extent of further cuts.

The Government Could Still Complicate the Interest Rate Outlook Further

While the Bank of England continues to keep its cards close to its chest amid ambiguous economic data, developments in fiscal policy could yet complicate matters. With speculation that the Chancellor now has a £50bn black hole in the nation’s finances to fill, her approach to tackling it could have implications for the path of monetary policy.

An approach based on spending cuts would complement the Bank’s efforts to bring inflation back to target, pulling down wider demand in the economy and easing inflationary pressures. Fresh tax rises by contrast (particularly those affecting consumables) could have the opposite impact and keep inflation problematically high for longer. We have already seen some of this affect with April’s tax rises on employers and the hike to the minimum wage - additional costs which were quickly passed back onto consumers. More actions along these lines could exacerbate inflationary pressures and drag out the economic pain the UK economy is currently enduring, as the Bank of England has to keep interest rates high to counteract cost pressures.

What Next for the Pound?

While the pound may be receiving a boost from the prospect of higher interest rates for longer, this effect may be short lived should other less favourable economic factors come to the forefront. Next week we will likely see a negative reading for Q2 GDP, highlighting the precarious state of the UK economy. The state of the government finances will also be of huge concern ahead of this Autumn’s budget, and markets could lose what little faith they have left if the Chancellor shies away from difficult decisions to balance the books. An outpouring from UK equities and bonds amid weak economic prospects could wipe out any FX support provided by a higher base interest rate.