UK inflation has fallen slightly but remains above the Bank of England’s target. According to data from the Office for National Statistics (ONS), UK CPI inflation eased slightly to 3.1% in September, from 3.2% in August—the highest in nine years.

The pound softened on Wednesday morning following the inflation data, as analysts expected the September reading to remain at 3.2%.

The slowdown is mostly due to the effects of lower prices of dining out last month compared to last September, when prices rose following the end of the Eat Out to Help Out scheme.

BoE

The data comes after Bank of England Governor Andrew Bailey said that the central bank will have to act to ease inflationary pressures – raising expectations for earlier rate hikes. According to economists, the bank’s task is a difficult one, as it expects inflation to reach 4% in the current quarter, with higher interest rates expected to ease it. However, the economy is struggling with higher costs and rising commodity prices, which interest rates have no power over.

Inflationary pressures rise

The cost of UK company goods and services continued to rise last month, affected by the supply chain crisis. Output price inflation rose to 6.7% per year in September, from 6% in August. Inflationary pressures are building in the economy as producers increased their prices, passing on costs to consumers. Companies reported that input prices increased by 11.4% year-on-year in September. Manufacturers faced commodity costs and transport costs due to shipping issues and a shortage in lorry drivers.

Economists: inflation is temporary

Economists are warning that September’s fall in inflation will be temporary. Costs rose due to supply issues and the higher energy price cap. The persistent supply-chain disruptions and energy price effects could push inflation higher above 4% early next year.

Senior economist at Royal London Asset Management Melanie Baker, expects more inflation. He warned that energy bills could push consumer price inflation further, which will reduce real income growth for many and add to some of the economic challenges in 2022.

Paul Dales of Capital Economics predicts inflation to reach 5% next April, when Ofgem hikes the energy price cap again. He noted: “However, this feels a bit like the lull before the storm as the 12% rise in utility prices on 1st October will probably lift CPI inflation to around 3.8% in October. And we think inflation could then climb to around 5.0% in April next year due to a further rise in utility prices and the upward influence from global/domestic product shortages. With underlying wage growth and inflation expectations rising, the BoE is concerned that higher inflation will become embedded in the system. That’s why it become much keener to raise interest rates.”

Dales explained that he doesn’t expect interest rates to be raised as far as 1.00% by the end of next year, since higher inflation will weaken the outlook for activity and with supply shortages easing, inflation will eventually fall to around 2% by the end of next year.

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Sterling reached a 20-month high against the euro on Monday after Bank of England Governor Andrew Bailey sent another signal that the central bank is heading towards raising interest rates as inflation risks rise. On Tuesday, the British currency held on to its near 20-month high gains against the euro and has reached a new one-month high against the US dollar. The main factor supporting the pound is expectations the BoE will raise rates, with investors speculating on a rise to 0.25% by December, or even earlier by November. Traders will be focusing on the release of the UK CPI inflation data for September on Wednesday and Friday’s PMI data for further clues.

Despite the pound’s excellent performance, some foreign exchange analysts are wondering whether the recent gains can be sustained in the long term.  

Warnings

Many economists and analysts have warned that the Bank of England’s intention to return interest rates to pre-pandemic levels could be a huge mistake that will impact on economic growth and push costs higher for households that are already under pressure. Higher interest rates, combined with zero growth and high inflation will hurt both the economy and the pound.

Others have noted that the pound won’t be supported for a long time by the Bank of England’s higher interest rates due to persisting supply chain issues and a struggling labour market.

Former Bank of England Monetary Policy Committee Member, David Blanchflower, said that raising rates very soon will be a disaster and “foolish.” He told BBC Radio 4 that interest rates are at 0.1% but economists warn that inflation could peak at 6.0%. Former MPC member Andrew Sentance laughed at Danny Blanchflower’s comments saying that he did not understand monetary policy.  With economists being torn about the prospect of higher interest rates, it is not surprising that there are so many differing views. However, markets have priced in a rate hike and expectations remain solid that an interest rate hike is possible in November.

Bank of England has been Misunderstood?

At the same time, analysts argue that the BoE Governor’s recent comments have been misunderstood and that a November rate rise is unlikely. Bailey has stated that the Bank will act if there are inflation risks in the medium-term and that the Monetary Policy Committee will wait and see until December when labour market data is available.

Also, for some analysts, the subsequent rate hikes being priced in by investors are a bit extreme as possibly two rates maximum by the end of 2022 sounds more reasonable. However, any recent hike expectations being priced out could also negatively impact on the pound.

Others have argued that, if indeed early interest rate hikes will be disastrous to the economy, then pricing out these rate hikes will possibly support the pound.  With so many different arguments, it is not yet clear how the pound will react. Some commentators have even gone as far as to suggest that the pound will fall whatever happens. For example, if the BoE ends up being more dovish and does not raise interest rates, it will end up disappointing markets. On the other hand, if it does deliver early rate hikes it might end up making a policy mistake. Nonetheless, Friday’s PMI data might offer further guidance: if it comes stronger than expected then the pound will strengthen and so will the case for raising interest rates.

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The pound is not in any crisis, Pound Sterling Live argued this morning, citing a range of media and newspapers that continue to claim that the pound is in trouble. There are potential dangers of course, especially from a return of Brexit anxieties, but there are also supportive factors such as the ongoing economic recovery and the prospect of an early Bank of England interest rate rise in late-2021/early-2022. Analysts at Pound Sterling Live also noted that a mixed set of views on the outlook of a currency is a common thing and does not signify a serious concern.

Pound concerns

At the same time, Bloomberg, has warned that the pound is going to fall, and said that investors are betting against the pound as they are worried that Bank of England’s efforts to reduce inflation would hurt consumer sentiment and the growth outlook.

Traders have increased their bets against the pound, as they expect the currency to fall at the fastest rate in more than two years. Canadian Imperial Bank of Commerce, RBC Europe Ltd., and Société Générale SA strategists are also expecting the pound to fall to levels last seen in late 2020. Bloomberg highlighted that sentiment was at its most bearish in seven months, as traders are not optimistic on the pound. 

The UK’s high inflation and low growth are also reasons for concern for Bank of America strategists who said “any strength in the pound is an opportunity to sell.” Analysts are concerned that inflation and the end of the furlough scheme will influence real incomes. Governor of the Bank of England Andrew Bailey warned of a potentially “very damaging” inflation period unless the Bank acts accordingly. By tightening its policy earlier, the Bank could also tighten household spending and increase mortgage payments, undermining the UK’s recovery.

Strategists for RBC have also noted that higher interest rates could push the pound lower, and many are concerned that if the Bank moves too fast, there will be a squeeze in real incomes, which is already evident due to high energy prices and tighter fiscal policy.

Pound not in crisis

While the pound to dollar rate might be weaker, the drop is not demonstrating a “chaotic” fall, Pound Sterling Live analysts have suggested. They have criticised different analysts who have linked supply chain issues to the UK’s performance. While such problems are real, Pound Sterling Live analysts have argued that such issues are not specific to the UK, and they pointed to the US and similar supply chain issues.  In regard to the fuel crisis, they criticised panic-buying and motorists who have run to fuel stations. They have also pointed out that the connection of the pound to emerging market currencies is false, as a lot of the weakness of the pound can be blamed to a stronger US dollar. As they say, many investors have mistakenly taken a very negative stance towards the pound, arguing that there are tougher times ahead and the macro-outlook for the pound is deteriorating.

The dollar’s safe-haven status and its higher demand in times of global economic nervousness has helped elevate it at the expense of the pound.  Pound Sterling Live has also clarified that the mixed range of forecasts offered by major financial institutions is not indicative of a crisis but is natural among other currencies. Risks of course remain, but they argue that the negative pound outlook is overstated.

 

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The pound was up against the euro on Wednesday, strengthened by higher UK bond yields and expectations of an earlier interest rate hike by the Bank of England. Sterling rose to a three-week high against the euro yesterday, as traders returned their attention to the prospect of interest rate hikes in Britain. The pound was down last week, due to rising inflation concerns, but it has now recovered.

Sterling’s recovery is mainly due to the prospect of the BoE raising interest rates sooner than expected, but analysts have commented that the pound should have risen even higher especially because of the important difference between the European and UK central banks. While the BoE has clearly stated its intention for an earlier rate hike, the European Central Bank has no plans to raise rates soon. Economists have warned that caution should be exercised though, as the pound’s gains might not be long-lived. It is still unclear whether the BoE will proceed to raise interest rates while the UK is facing ongoing supply problems.

Inflation

On Tuesday, British Prime Minister Boris Johnson said inflation fears were baseless. The final reading of the IHS Markit/CIPS composite Purchasing Managers’ Index showed that companies increased prices at the fastest pace on record, following shortages of staff, raw materials and transport.

Brexit

The pound has yet to react on Brexit risks after the UK told the European Union on Monday it would  “trigger safeguard measures in their divorce deal if the bloc failed to agree to changes to smooth trade with Northern Ireland.” Speaking at the Conservatives' annual conference in Manchester, Brexit minister David Frost stated that "Without an agreed solution soon, we will need to act, using the Article 16 safeguard mechanism, to address the impact the protocol is having on Northern Ireland." The EU is putting together a package of measures to ease the passage of goods from Britain to Northern Ireland, using flexibilities in the protocol, which will announce next week.

Tighter policy could weaken pound

Goldman Sachs Asset Management has said that tighter policy could weaken Sterling. The firm’s strategist for the global fixed income team said that high inflation and energy prices, and Brexit implications could further complicate the inflation outlook. Fears of higher inflation combined with the ongoing supply-chain crisis and an end to the government’s furlough program have worried investors who believe the BoE may choose to raise interest rates sooner than necessary, risking economic recovery.

Other firms and financial analysts are less concerned as challenges are not seen as dangerous and are merely transitory. They don’t believe that the Bank will be forced into a dangerously fast pace of tightening.

What to watch

A key indicator to watch is the UK's labour market as unemployment is expected to increase in October since the government's job support scheme ended on the 30th of September and furloughed staff might not be able to return to their old jobs. The furlough scheme which started in March 2020, supported 11.6 million jobs across the UK and government figures suggest that around a million people were still on furlough when it ended.

If unemployment is lower than expectations, the consensus is that the Bank could move towards a rate hike as a strong labour market will increase the potential for wage rises which push inflation higher.

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The pound is expected to stabilise and rise further according to analysts as investor sentiment is strengthened and the Bank of England is moving toward tightening its policy next year.

The pound stabilised against the euro but remains to be seen how well it will perform against the dollar as Friday’s jobs report will determine the outcome.

Pound is in recovery mode now

The pound dropped last week after concerned investors sold Sterling against the euro and the US dollar fearing higher inflation following the global energy crisis. Higher gas prices and panic-buying at petrol stations due to a shortage of lorry drivers, signalled weakening economic growth and hurt market sentiment. By the beginning of the new month, however, Sterling managed to recover, as analysts noted that perhaps the currency overreacted to the fuel crisis in the UK.

The pound rose, leaving behind last week’s losses boosted by Thursday’s release of UK GDP data that showed the economy grew more than expected in the second quarter. This will also offer more evidence that the economy is growing, and the Bank of England is on track to raise interest rates in early 2022.

Sterling is a good buy

Analysts believe that due to its long-term undervaluation, the pound is an attractive investment. In general, economists believe that economic growth will continue, and the economy will return to its pre-pandemic levels in the first quarter of 2022, earlier than anticipated.

Many currency strategists believe that the pound will also strengthen against other major G10 currencies in the short term and even for longer against the euro. The Bank’s earlier raising of interest rates and policy tightening will prove to be fundamental to the British currency’s performance.

If investors find the currency appealing due to its rate, then this will offer further support to the currency. However, global developments that could influence the pound remain a constant risk for Sterling. As we have noted in the past, the pound is sensitive to global economic sentiment and tends to depreciate when global stock markets fall. With concerns about global economic growth weakening and inflation rising, it is not unsurprising if the pound reacts with more volatility.

Higher inflation remains a constant risk for the pound

Economists said that higher inflation in major economies will lead to the gradual depreciation of those countries’ currencies. For example, the US and the UK, along with Canada and Australia are at risk of prolonged higher inflation, which might weaken their currencies compared to other countries in Asia or Europe where inflation remains within normal levels. Talking on Tuesday during an interview, Prime Minister Boris Johnson, said that inflationary pressures will subside as supply increases. He stated: “What you are seeing is demand, growing demand sucking in gas from Russia or wherever, you are seeing demand for lorry drivers globally and that has an inflationary effect and as that clears, as supply meets demand then inflation abates."

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The pound rose in response to Bank of England Governor Andrew Bailey’s comments that a 2022 rate hike is possible. While soon after, the pound was unable to hold its gains, the revelation by the central bank was important as it confirmed market expectations that a rate rise in the first half of 2022 is possible.

UK tax hike

The pound was higher, especially after it lost ground due to an announcement on Tuesday of a UK tax hike. The proposal, which on Wednesday was backed by British lawmakers in a parliamentary vote, intends to raise taxes to fund the health and social care systems. The government will raise the rate of National Insurance payroll taxes paid by both workers and companies by 1.25 percentage points. The tax on shareholder dividends will also rise by the same percentage. The plan is expected to help raise 12 billion pounds ($17 billion) a year.

Bank of England Vote to Raise Interest Rates

Andrew Bailey clarified that the eight members of the Monetary Policy Committee (MPC) were divided as to whether the UK economy was healthy enough for interest rates to be raised. In a testimony to the Treasury Select Committee of the House of Commons, Bailey noted that the vote was split: “Let me condition this by the fact that it was an unusual meeting because there were only eight members of the committee - so it actually was four-all.” In the August MPC meeting, however, all 8 members voted to keep interest rates unchanged. So, the bank feels more confident about the state of the economy now. Nonetheless, Bailey explained that the

Bailey said that the conditions were not yet sufficient. Markets expect the MPC to end quantitative easing in December before proceeding to raise interest rates. While Silvana Tenreyro did not believe that the conditions have been met yet, other members of the MPC including Bailey, Dave Ramsden and Ben Broadbent and Michael Saunders, all believed that the minimum conditions had been met for a hike. The remaining members of the MPC, Gertjan Vlieghe, Jon Cunliffe and Jonathan Haskel were possibly the more dovish members who believe that conditions have not been met yet.

Has the 2022 interest rate already been priced in by markets?

It would appear that it has been priced in by markets, as the pound was unable to hold gains. For the pound to strengthen, the Bank will need to provide more evidence of future rate hikes. If inflation stays above the Bank’s 2.0 % target, then the need to raise interest rates will rise too. The Bank’s economists expect inflation to rise 4.0% in 2021 but fall back in 2022. Bailey said that some issues could disappear, but unemployment and job vacancy issues could persist. Higher commodity prices and problems with supply chains could go away, but the labour market will need to improve consistently.  

Economists are concerned that after the end of the government's furlough scheme, unemployment will rise. But with many businesses finding it difficult to fill in their vacancies, the end of the support program might be positive.

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Sterling fell on Tuesday against a stronger dollar, following a drop at the start of the week due to the UK’s economic slowdown.

Weak surveys push pound lower

While earlier this year, markets were upbeat about the UK’s economic prospects as the fast pace of the Covid-19 vaccinations injected confidence about reopening the economy and a quick economic rebound, more recently indications of a slowdown have pushed the pound lower. Additionally, the combination of factors such as Covid-19 that forced lots of employees to stay at home and hurt businesses, as well as global supply issues due to Brexit, have also drove the British currency lower.

On Monday, it fell after a survey of purchasing managers showed that the UK construction industry was hurt by a shortage of building supplies which weakened its growth last month. Friday’s PMI data also showed that growth in the services sector slowed down in August compared with July.

Bank of England’s Michael Saunders

The positive comments by Bank of England’s policymaker Michael Saunders did not have a significant effect on the pound. Saunders said the central bank may need to raise interest rates next year if both growth and inflation continue to rise. His comments did not surprise markets as investors possibly do not consider him as an influential voice of the MPC (Monetary Policy Committee).

Saunders believes that the Bank could stop its stimulus programme and that the continued purchases could put inflation expectations at risk. In an online event hosted by Intuit, Saunders explained why he voted to reduce the Bank’s QE bond-buying stimulus programme at last month’s MPC meeting: “My own view at the August meeting was that with the recovery in the economy, and inflation back to target, we no longer need as much monetary stimulus as previously.”

He also noted that interest rates could rise when the health of the economy is undeniably strong: “As to when I think interest rates might rise, that would depend on the economic outlook.” He added: “If the economy continues to recover, and inflation shows signs of being more persistent, then it might be right to think of interest rates going up in the next year or so. But that is not a promise and depends on economic conditions.” In relation to inflation, Saunders said that he was worried “that continuing with asset purchases, when CPI inflation is 4% and the output gap is closed - that is the likely situation later this year - might well cause medium-term inflation expectations to drift higher. Such an outcome could well require a more substantial tightening of monetary policy later, and might limit the committee’s scope to respond promptly the next time the economy needs more stimulus.”

Saunders argued that the UK economy has recovered and that the pandemic’s effects will prove to be minimal in the log run. Brexit, on the other hand, will have long term repercussions. For him, ending the current asset purchase programme would not hurt economic recovery as it would still  leave a “very supportive monetary stance in place.”

Last month the BoE said that it could start reducing its financial support which was so necessary during the Covid-19 pandemic and lockdowns, and it has explained how it will do so after it has raised interest rates.  

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The pound fell against the euro and US dollar ahead of Thursday's Bank of England policy meeting. The fall is a result of investors’ belief that the pound will fall further. More generally, the third wave in Covid-19 infections and the slowdown in business activity has not helped boost market sentiment. If the bank strikes a cautious tone, market analysts believe that the pound might suffer.

Bank of England

Markets are expecting the Bank to keep interest rates and its quantitative programme the same, without making any major changes to its policy. But, it is also expected to readjust its economic forecasts and provide further guidance about the end of its quantitative easing programme while also offering a general outlook for interest rates. Thursday’s policy update coincides with the release of the quarterly Monetary Policy Report which will possibly shed some more light on when a 2022 interest rate rise will happen.

If the quantitative easing programme is reduced or there is a larger than expected increase to the BoE's inflation projections, the pound could get a boost. The latter will increase the possibility of a rate increase much earlier than expected. In general, if the bank provides more clarity on how it will begin cutting down its stimulus programme, then the pound will most likely rise.

Bank of America analysts are very hawkish and positive and expect the Bank of England to raise interest rates to 0.25% in May 2022. If the bank does signal a rate rise for 2022, then the pound could rise higher.

Outlook for pound

For economists and analysts, buying Sterling with the expectation that it will rise is something that makes sense, despite the dissenting voices of some of the bank’s members. While getting the economy back and running to pre-pandemic levels might take a while, the path towards normalisation seems clear. The pound’s path, however, might find possible obstacles if the US dollar rises.

Other analysts, believe that the fundamental backdrop remains unsure for Sterling and that any gains are short-lived, as they remain cautious.

Economists at HSBC do not expect any major shifts at the Bank of England’s meeting on Thursday, so the GBP/USD pair may experience some downside pressure. According to them, the cautious tone of the bank will hurt the pound. They said: “The GBP remains somewhat attuned to global risk appetite and so may see its fortunes partly determined by this factor, but local drivers seem to be getting more dominant and suggest further depreciation pressure over the near term. Given the rapid spread of the COVID-19 Delta variant, the removal of most remaining restrictions on 19 July has failed to provide the GBP with a boost. At the Bank of England’s (BoE) meeting on 5 August, a cautious tone (warning against the dangers of premature tightening) is likely to be prominent, as uncertainty remains high and most policymakers view the inflation upswing as temporary. The rates market prices in a 15bp hike in May 2022 for now, and so if the BoE repeats its cautious tone, this may pose some downside risks to the GBP.”

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The outlook for Sterling will remain at risk as market analysts are cautious for the UK currency, especially with the new week having started with further pound declines.

Bank of England policy meeting

While the pound has enjoyed gains in the beginning of the new year and until recently, analysts are slowly becoming more cautious following last week’s sharp decline with traders less confident in the currency. Therefore, traders will focus on this week’s Bank of England policy meeting on Thursday for some direction for Sterling. If the Bank of England's Monetary Policy Committee delivers a more hawkish than expected message then the pound could regain some of its recent losses against the US dollar, analysts believe. On Thursday, the Bank of England will provide their latest assessment on the UK economy but is not expected to take any action and it will leave interest rates unchanged. It will be in August’s policy report that any possible major changes in the Bank’s direction will be announced, and the market will focus on such expectations and whether economic recovery will drive the Bank to change interest rates next year. If the Bank reveals any signs that it is going to move towards this direction, then the pound might be lifted by the end of the week.

Potential dangers for the pound

Some analysts believe that much of the positive news is already priced in and that the pound will be vulnerable to downside moves if economic data disappoints. It has also been noted that we should be more optimistic as the pound has responded rather well to economic data, but that currency risks are indeed real and could potentially hurt the pound. For example, there are currency risks related to the futures market as there are traders who are holding long positions—meaning they have purchased Sterling and are waiting for the currency’s price to go up—and when those positions are undone and the pound is sold, they will expose the pound to a fall.

There are also risks regarding the pound’s performance and the loss of momentum. The Sterling 2021 rally has now stopped, and this is a possible reason for concern.

Another possible reason for concern is the rising tensions between the UK and EU and a potential trade war about the Northern Ireland protocol. The EU has threatened the UK with tariffs on UK exports if Britain fails to implement the Northern Ireland protocol. Analysts remain cautious as discussions continue and further potential challenges arise. It was announced last week that the UK government requested from the EU the suspension of some elements regarding the Northern Ireland protocol until October, while they strive to reach an agreement on transporting chilled meat products from Great Britain to Northern Ireland. Any news regarding tensions between the UK and EU on the Northern Ireland protocol could trigger Sterling volatility.

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The British pound has come under pressure as there are concerns that the UK’s exit from the lockdown will be delayed. With Covid-19 cases on the rise, the government might postpone the final unlocking due on 21st of June. As Health Secretary Matt Hancock said, the government is "absolutely open" to delaying its plans to ease the restrictions, with a possible two-week delay until the 5th of July. This means that any possible delays will affect confidence in the UK economic rebound, and, consequently, hurt the pound which has had a solid performance throughout 2021.

Lockdown Easing, Indian variant and pound performance

Covid restrictions easing could be disrupted as scientists believe that the Indian variant (known as the Delta variant and B.1.617.2) could spread almost 50% faster than the previous strain in the UK, known as the Kent variant. While the Indian variant might be the cause for potential delays, many analysts believe that this is not enough reason for investors and traders to become especially concerned about the pound’s outlook, as the backdrop remains positive. As economists at ING Bank said, "a 'June pause' probably won't significantly derail the UK's recovery,” unless market confidence “goes into reverse.”

This will also be influenced by how strong business and consumer confidence will be as they will determine whether there will be the necessary funds and investment to drive economic growth. Economic data has up till now been positive with increased bookings in restaurants and pubs, as activity picks up. Economists believe that economic growth data for the second quarter of 2021 will be stronger than many have anticipated, and this will offer further support to Sterling. The potential for the UK economy to beat expectations could also increase confidence and possibly drive the Bank of England (BoE) to raise interest rates sooner than expected.

For the pound but also for other currencies, positive news that central banks will exit their pandemic support programmes will offer extra support. Already, we have seen that for those central banks which have reduced their quantitative easing programme and signalled that interest rates will rise, have seen their currencies outperform.

In general, the majority of analysts believes that the pound will benefit as the economy improves in the coming weeks and months, driven mostly by consumer savings during the various lockdowns. However, a rising number in Covid cases and further restrictions could dampen sentiment.

Short-lived pound weakness

For many economists and research analysts, a potential delay in the easing of restrictions will be damaging, but for others, such weakness will only be short-lived. It is believed the pound will be sold briefly by traders, but then renewed interest will resume.

While the pandemic will continue to affect the economy and the pound, other factors such as economic performance, vaccines, and rising UK real yields will also have an impact on the pound’s performance.

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