Strong pound masks weak British economy

The British pound is rising thanks to higher interest rate expectations, but the underlying economy looks weak. Rapprochement with Europe is intended to boost growth, while inflation and geopolitical uncertainty are putting monetary policy under pressure.

Almost ten years after a narrow majority of the British population voted to leave the EU, the Labour government is launching various initiatives to strengthen ties with Europe. On Monday, a high-profile delegation traveled to Brussels for political talks. Today, Finance Minister Rachel Reeves emphasized that closer cooperation will pay off on both sides of the Channel. With this, the Cabinet primarily aims to boost economic growth. In January, the growth rate came in at 0%. Due to the sharp rise in energy prices caused by the war in Iran, the chance of a sudden acceleration is very small.

Economic boost
Although increased trade with the mainland would be an economic boost for the United Kingdom, the first signs are not favorable. In the British media, attention is focused primarily on a minor controversy regarding annual tuition fees for European students. According to Brussels, that rate should be the same as the 9.500 pounds paid by British students. According to universities, this applies only to those entering via a European exchange program. For other students, the international rate applies, which can rise to more than 60.000 pounds per year. Politicians on both sides of the table have years of experience with Brexit negotiations, but a deal is not yet within reach.

Erase interest rate plans
Trade talks are coming under increasing pressure as another potential economic tailwind has disappeared. The Bank of England (BoE) had already tentatively scheduled an interest rate cut for this coming Thursday's meeting. However, due to the conflict in the Middle East, this plan may have to be erased. British inflation at 3,0% is significantly higher than the BoE target of 2%. Polls indicate that the public's perceived temperature regarding inflation is even higher. In view of the sharply rising oil price and the uncertainty regarding the duration of the war in Iran, the central bank simply cannot afford to lower the policy rate at this time.

Step back
The prospect that the 1,5 percentage point interest rate gap in the United Kingdom's favor will remain in place for the time being is a major reason why the pound is gaining ground against the euro in March. Since the Bank of England will not reveal its hand regarding possible interest rate scenarios for 2026 until April, this situation will not change for the time being. In the somewhat longer term, the picture looks a bit different. British unemployment has risen in recent years from less than 4% to over 5%. As a result, the risk of inflation fueled by wage increases is somewhat smaller than in the past. If peace breaks out in the Middle East soon, the erased interest rate cuts could be reinstated. And in that scenario, the pound could take a step back again.

Joost Derks

Joost Derks is a currency specialist at iBanFirst. He has over twenty years of experience in the currency world. This column reflects his personal opinion and is not intended as professional (investment) advice.

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