The pound dropped against the euro last week but could slowly recover if the euro does not rise any further. Sterling rose sharply after the Bank of England’s Thursday decision to lift the Bank Rate from 0.25% to 0.50%, but experienced losses when Governor Andrew Bailey and other members of the Bank’s Monetary Policy Committee warned of risks to economic growth and that meeting market expectations for the Bank Rate could eventually lead inflation to fall below the Bank’s target level of 2%.

The forecast for inflation anticipates inflation to remain elevated above the Bank’s target for more than two years and to fall below 2% in 2025. This means that the Bank might avoid raising rates in 2023, despite market expectations.

Thursday’s European Central Bank (ECB) policy decision

Sterling fell due to the Bank of England’s cautious tone and concerns about the effects of the recent increase in energy and international traded goods prices. But it was the hawkish shift of the European Central Bank last Thursday that also deflated the pound and boosted the euro. The foreign exchange market moved sharply and resulted in the euro rising higher. After ECB president Christine Lagarde said that Eurozone inflation risks have increased, financial markets expectations for a potential end of negative interest rates rose. The euro rally could extend, and this will be an ongoing risk for the pound.

Rising inflation and cost of living squeeze

Economists have warned on Monday that inflation will hit UK economic growth this year as consumers have to deal with the rising cost of living.  In its latest quarterly assessment of the economy the EY Item Club has cut its forecast for UK economic growth this year to 4.9%, as the squeeze on households’ spending power and the omicron variant slow economic recovery. The EY predicts inflation to hit 7% in the spring and real wages to fall. They also expect the Bank of England to hike the Bank Rate to 1% by the end of this year.

Hywel Ball, EY’s UK chair, says: “The forecast shows that the economy’s bounce back in 2021 was stronger-than-expected and Omicron’s economic impact is likely to be temporary and limited. While the economy and UK businesses may have a softer launch pad for growth this year, they will still benefit from a number of tailwinds in 2022 and 2023. But blowing in the opposite direction will be a squeeze on household spending power which is expected to be a bigger headwind for the economy than the Omicron variant. Inflation is set to reach its highest level in thirty years by the spring and will be well ahead of pay growth. Although the latest forecast says that the economic scarring from the pandemic is likely to be minimal, policymakers still face the challenge of how they help support households through the forthcoming squeeze on their finances and give companies the confidence needed to unlock business investment. The push towards Net Zero certainly creates an opportunity for investment growth.”

What to watch this week

The pound will be sensitive to any comments made by BoE Chief Economist Huw Pill on Wednesday’s online event with the Society of Professional Economists and Governor Andrew Bailey on Thursday’s online event hosted by TheCityUK. Friday’s UK GDP figures for December and the final quarter will also reflect the effects of the Omicron variant on economic activity into the end of the year. The GDP is expected to have fallen by -0.5% in December and to have grown by 1.1% for the final quarter.

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