Pound Sterling Weakness Could be the Bank of England's Next Headache

"Further increases in long-term inflation expectations or a further sharp GBP depreciation could lead to a faster hiking pace in coming months" - Goldman Sachs.

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The rapid fall in the value of the British Pound following Thursday's Bank of England policy announcement and Monetary Policy Report could raise the prospect of additional rate hikes, according to analysts.

Pound exchange rates fell sharply in the wake of the Bank's decision to hike by 25 basis points and presentation of a set of dire economic forecasts.

It was those forecasts, and the message contained within them that the market is anticipating too many hikes, that caused a recalibration lower in expectations, and the Pound.

But the Pound's fall is in itself inflationary given the UK is an importing nation: a lower Sterling exchange rate inevitably pushes up the value of imports and contributes to inflation.

This is particularly true of the Pound-Euro exchange rate, given Europe is the UK's primary import provider.

The Bank of England has indicated in the past that it estimates a 10% depreciation of the Sterling Trade Weighted Index boosts the headline rate of CPI inflation in two years’ time by 0.75% and 2.75% after four years.

"Sterling weakness is adding to the dilemma facing the Bank of England as it attempts to fight rising UK inflation without hurting Britain's economy too much in the process," says Robert Howard, a Reuters market analyst.

The Pound-Euro exchange rate fell 1.44% on Thursday alone, for the month of May it has lost 2.0%. The Pound-Dollar exchange rate is facing a more dire loss of 4.30% already for May.

The Bank of England currently forecasts inflation to peak close to 10% later in 2022, this figure would have to be revised higher were the Pound to fall and all other conditions remain equal.

"If GBP/USD extends south through 1.20, it may lessen the probability of more than two Monetary Policy Committee members voting to keep the Bank Rate at 1% next month, for fear of adding to sterling and inflation woes," says Howard.

Economist Steffan Ball at Goldman Sachs says the Bank looks as though it will want to pause rate hikes in the second half of the year for fear of contributing to an economic recession.

However, the Bank might not have the luxury of the pause if the Pound continues to lose value.

"A pause in the hiking cycle remains a risk if the outlook deteriorates more than in our baseline projection, but further increases in long-term inflation expectations or a further sharp GBP depreciation could lead to a faster hiking pace in coming months," says Ball.

Above: GBP against EUR (blue), USD (orange) and AUD (turquoise) in the hours following the Thursday rate decision.

Andrew Sentance, former MPC member and Senior Adviser at Cambridge Econometrics, says with inflation now forecast to rise to just over 10% later this year, "the MPC’s quarter point rise seems an inadequate response".

"A 0.5 pc rise would have sent a stronger signal. Further significant rate rises will be needed this year and next," he adds.

The Pound remains under pressure ahead of the weekend as further post-BoE follow through sales continue, with GBP/EUR down a further 0.40% at 1.1670 and the GBP/USD down another 0.17% at 1.2341.