Is the Bank of England playing a game?

With a sharp rise in the British pound, financial markets are opting for an interest rate hike by the Bank of England. That interest rate move may be taking longer than everyone thinks.

The Brexit negotiations between Britain and the European Union have been postponed for a week, but the pound is still in the spotlight. The currency shot up nearly 3% last week against a basket of other currencies such as the euro, dollar and yen. That is the largest gain in territory in more than 8 years. It is also a striking trend reversal. A few weeks ago, after a price drop of 25% within 2 years, the pound still seemed well on its way to parity with the euro.

The pound's rally is fueled by traders opting for a Bank of England (BOE) rate hike. Last Thursday, September 14, BOE Chairman Mark Carney said the possibility of an interest rate move has definitely increased. The message came in extra hard, because Carney's comment was repeated 1 day later by BOE governor Gertjan Vlieghe. Vlieghe is known as a strong supporter of loose monetary policy within the decision-making committee. Shortly after the Brexit referendum, he was the first to advocate a rate cut.

Shot through the bow
With the strong appreciation of the pound, the Bank of England has made a direct hit on the currency markets. Chances are, however, that the intent was just to give a shot across the bow. Many market parties assume that an increase in interest rates at the next meeting (on 2 November) is inevitable.

In recent years, however, the Bank of England has built up a reputation for firm words, which are not followed by firm actions. Despite the bank hinting at an interest rate move several times, it has been more than 10 years since the interest rate was last really raised.

At first glance, there is now a good reason to raise interest rates. Inflation has risen to almost 3%, well above the official target of 2%. In addition to the inflation level, the bank also looks at what lies behind it. The rising inflation is largely attributable to the fall in the exchange rate of the pound. After the recent rebound, 1 pound now costs €1,13, compared to more than €1,30 just before the polls.

Wages are not rising fast enough
Foreign products and services cost a lot more when converted to the British currency. Lego has already raised prices in the UK by 5%. Wage growth does not keep pace with this kind of price increase. In the first half of the year, salaries were on average 2% higher than twelve months previously. An interest rate hike that is too early creates the risk that economic growth will be held back at the same time that the purchasing power of many households is under pressure.

In addition, political uncertainty is very high. The Brexit negotiations, which will start on Monday 25 September, could have a significant impact on the value of the pound. For the time being, it is therefore much too early to piggyback on the recovery of the British currency. It is also unwise to speculate on another relapse. If the Bank of England already puts the pound on the rise with a shot across the bow, after all, it can be guessed what will happen if the bank actually raises interest rates sooner or later.

Lawrence Martins

Laurens Maartens is a currency expert at the Dutch Payment and Exchange Company (NBWM). Maartens analyzes current currency developments and also provides lectures and training in the field of currency management.

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