If the Bank of England’s first interest rate rise in over a decade was aimed in part at shoring up sterling and its impact on above-target UK inflation, then it has backfired already.
As financial markets doubt the wisdom of raising rates in what is the European Union’s slowest-growing economy, sterling’s fall on Thursday suggests the Bank’s reversal of last year’s emergency post-Brexit rate cut is more symbolic rather than a real attempt to rein in credit growth.
The pound has responded to the first hike since July 2007 with its biggest fall against a trade-weighted basket of currencies in almost five months.
And sterling is now comfortably back below where it was against the dollar on Sept. 14 when the Bank gave the clearest signal to date that it planned to lift borrowing costs.
UK bond and rates markets reflected traders’ skepticism that rates will rise much more in the coming years. The two-year yield tumbled 10 basis points to 0.40 percent, putting it below the six-month yield of 0.46 percent – an inversion at the short end of the UK rates curve.
In its statement accompanying the decision to return rates to their pre-Brexit referendum level of 0.5 percent from a record low 0.25 percent, the Bank said any future increases will be “very gradual” in pace and to a “limited” extent.
The Bank’s Inflation Report issued on the same day indicated that only two further quarter percentage-point hikes over the next three years would be a reasonable expectation.
So, the ultimate “dovish” hike, to which sterling reacted quickly and decisively.
It’s worth going back to the late summer and remembering the UK economic and financial backdrop that led to the Bank’s surprise signal on Sept. 14 that rates would soon go up.
The pound was down 15 percent since the June 2016 Brexit referendum and threatening to lurch to new historic lows; inflation was taking off; real wages were once again falling; and all the while the economy was slowing noticeably amid Brexit-related uncertainty – Britain was the slowest-growing economy of all 28 EU countries in the second quarter.
The high inflation and sliding real earnings, both fueled by a weak exchange rate, would threaten to destabilize consumer spending, the bedrock of the economy.
So it’s clear why the Bank of England might have been tempted to at least try and put a floor under sterling.
And for a while it worked. Sterling recovered ground, and in late September reached a four-month high on a trade-weighted basis.
But returning interest rates to where they were for the seven years up to the Brexit referendum and signaling only another two hikes by 2020 may not be enough to sustain that momentum, which had started to fade.
The first of these rate increases isn’t fully priced in until November/December next year, and the second one not until 2020. So that means only one rate increase before Britain is scheduled to leave the EU in March 2019. A lot can happen between now and then, and little of it with Carney’s control.
“Brexit negotiations will determine much of the fate of the economy and the pound, and he has little scope to control either over the next twelve months,” said BlackRock’s Ben Edwards.
If the pound does begin drifting lower, inflation will remain elevated and real earnings will keep sinking – and Carney and his colleagues will find themselves back at square one.