Investors expect that the Bank of England (BoE) will raise interest rates at its monetary policy meeting on Thursday. Andrew Bailey, governor of the BoE, is anticipated to increase the interest rate by 25 basis points (bps). A rate increase of 25 basis points is considered insufficient to alleviate price pressures.

Barclays' foreign exchange analysts predict that the pound would likely decline; however, Goldman Sachs is more optimistic about the UK currency's prospects, particularly when compared to the euro.

Interest rate hike expectations and the pound

The pound has risen the last few months against both the euro and the US dollar, but Thursday’s BoE announcement will set the tone and test the pound. The biggest risk for the pound will be the size of the hike and pound forecasts. If the Bank fails to meet expectations and delivers another 25 basis point rate hike then the pound could weaken. Following the governor’s and other members of the Monetary Policy Committee (MPC) who have expressed the bank’s willingness to act and control inflation, the market has now almost fully "priced" in a 50bp raise.

What foreign exchange analysts have said

Analyst at Barclays in London, Marek Raczko, said: "A delivery of 50bp could trigger a small knee-jerk rally in the pound, while a 25bp move should see a bigger sell-off." However, he explained that any increase in the pound will be temporary since the BoE’s updated forecasts could warn about stagflation.

This may be similar to May’s policy update, where the BoE raised rates but released forecasts showing that inflation would fall below the 2.0% target over the medium-term while growth would fall into negative by next year. Following May’s announcement, the pound weakened. Against the euro, the pound performed better after the BoE’s update based on its promise to act more forcefully.

For example, if the bank mentions any risks of stagflation or sounds dovish in its forward guidance regarding future hikes, then this will push the pound lower.

Currency strategists at Goldman Sachs are more confident and expect the MPC to hike by 50bp breaking away from their usual 25bp rate hike. As Zach Pandl, co-head of FX Strategy at Goldman Sachs in New York said: "The key question for the meeting next week in our view is how policymakers will balance the strong spot wage and inflation data against the gathering storm clouds over the Euro area economy." "We have argued that the MPC’s more balanced approach to getting inflation lower would lead to Sterling underperformance, and we do not expect a wholesale shift away from this strategy at this meeting,” he added.

A 50bp hike is a considerable change in the Bank's approach and will definitely make the bank stand out, especially against the US central bank, since markets have now lowered their expectations for further rate hikes by the Federal Reserve.  

Stagflation warning

A dire warning from a leading think tank may also influence the bank’s decision tomorrow. The UK is heading into a period of stagflation according to the National Institute of Economic and Social Research (NIESR). The think tank warned that the country will experience a period of high inflation and a possible recession as the cost-of-living crisis hits households.

In its latest quarterly outlook of the UK economy, NIESR has said that CPI inflation will peak close to 11 per cent in the fourth quarter of this year, when energy bills will surge over £3,000 per year.

“The UK economy is heading into a period of stagflation with high inflation and a recession hitting the economy simultaneously,” said Stephen Millard, NIESR’s deputy director for macroeconomics. “It’s now up to the Monetary Policy Committee to make sure inflation does come down next year and the new Chancellor to support those households most affected by the recession and cost-of-living squeeze,” Millard said.

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The pound fell and remains vulnerable to global growth concerns and the ongoing fuel crisis in the UK as analysts fear of a difficult winter ahead. The fuel crisis has sparked concerns that growth will slow down, while rising inflation will aggravate problems. The panic buying of petrol was the result of fears regarding supply chain issues as the UK is struggling to recover from the Coronavirus pandemic.  

150 soldiers prepared to drive tankers

UK business secretary Kwasi Kwarteng has said that military tanker drivers are ready to help with the fuel crisis and transport petrol to stations, as 150 soldiers will be driving tankers within a few days. Despite calls to motorists to stop panic-buying at petrol stations, queues have continued. Kwarteng admitted that the last few days have been difficult, with large queues, but the situation is stabilising and that with soldiers driving the tanker fleet and getting petrol into the forecourts, things will return back to normal soon. In regard to issues in the run-up to Christmas, where people are busier, Kwarteng explained that it was difficult to make any predictions, but, nonetheless, he reiterated that the “situation is stabilising.”

The fuel crisis has generated more concerns about who will have priority access and many unions have requested that doctors, nurses and other essential workers to be given priority access to fuel. The Prime Minister has resisted this. The worst shortages have been experienced in London and English cities with fights and, in one incident in south London, a driver pulling a knife.

The supply chain issue and the shortage of lorry drivers is linked to Brexit and the government has said that it will deal with the driver shortage by providing temporary visas to 5,000 foreign drivers.

Bank of England to raise interest rates

The Bank of England will be forced to raise interest rates to fight inflation. Markets are concerned about the Bank having to tighten its policy against a weak background, with analysts describing it as a “stagflation story.”

The UK is especially vulnerable as it appears to be the hardest hit by the energy and supply chain crisis. The energy crisis is affecting economic activity, while the rising gas prices are a real issue for the currency. With the ongoing energy crisis, the pound will remain under pressure, and once it clears it will be able to stabilise. The gas price surge is also a global phenomenon as Asian countries are also competing for the same supplies. Growing fears of an energy shortage in China have led to Sinopec, an LNG importer, to outbid European competitors.

Traders and analysts are now focusing on the fuel crisis as they are worried about how the UK economy will fare and whether the current crisis is temporary or will last longer.

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