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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