Pound to Euro Rate Rallies Following PMI Beat, But Reeves' Job Tax A Major Threat for 2025

File image of Chancellor Rachel Reeves. Image: Kirsty O'Connor / HM Treasury.

Pound Sterling recovered some recent losses against the Euro after December's flash PMI beat expectations. However, relief is limited by signs the labour market is softening.

The Pound to Euro (GBP/EUR) exchange rate is 0.25% higher on the day at 1.2045 after S&P Global said the UK's services PMI rose to 51.4 in December from 50.8 in November, beating expectations for 50.9.

Although the UK's dominant sector saw improvement, the manufacturing sector is not faring as well. The Manufacturing PMI fell to 47.3 from 48 in November, undershooting consensus at 48.4.

The Composite PMI, which balances these data to give a more accurate gauge of the broader economy, remained at 50.5.

Drilling into the report's details confirms the UK economy has cooled notably since the first half of the year. S&P Global said survey respondents widely commented on growth headwinds from fragile consumer confidence, tighter corporate budgets, and cutbacks to non-essential spending.

Upside in pound exchange rates will be restricted by the news that a combination of softer demand, rising employment costs, and squeezed margins will contribute to a further reduction in private sector headcounts at the end of 2024. The latest decline in workforce numbers was the steepest since January 2021.

A deteriorating labour market is the single most significant headwind facing the Pound in 2025.

The Bank of England closely monitors employment data, judging that rising unemployment will ease wage increases, which will, in turn, bring inflation down.

"Overall, the UK December PMIs paint an unpleasant picture of sluggish activity trends, notably deteriorating employment and strengthening inflationary pressures, all of which appear to have been exacerbated by the policy to increase employer National Insurance Contribution (NICs) rates announced at the budget," says Abbas Khan, an economist at Barclays in London.

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The Bank of England meets again on Thursday, and these findings could prompt more than one member of the Monetary Policy Committee (MPC) to vote for an interest rate cut.

The Pound can soften into the weekend if several MPC members vote for a cut.

S&P Global says service providers recorded a particularly steep decline in employment at the end of 2024, which was mainly linked to the non-replacement of voluntary leavers in response to rising employment costs.

Above: The PMI data are consistent with a static economy.

Economists and businesses have warned that Chancellor Rachel Reeves' decision to raise the tax paid on employer salaries would lead to increased unemployment.

All the data now suggests these warnings are starting to play out.

"Firms are responding to the increase in National Insurance contributions and new regulations around staffing with a marked pull-back in hiring, causing employment to fall in December at the fastest rate since the global financial crisis in 2009 if the pandemic is excluded," says Chris Williamson, Chief Business Economist at S&P Global Market Intelligence.

Some firms also noted that forthcoming increases in employers' National Insurance contributions had encouraged cutbacks to working hours and longer-term efforts to restructure workforces.

Furthermore, rising salary payments and elevated domestic inflationary pressures continued to push up cost burdens across the private sector in December.

Overall, the rate of input price inflation accelerated for the second month running, reaching its strongest level since April. Manufacturers recorded the steepest rise in purchasing prices since January 2023.

The Bank of England will be concerned that these increased costs will be passed on to consumers via higher charging higher prices.

This can limit the extent to which the Bank can cut interest rates in the coming months, which can mean the Pound-Euro rate will stay elevated, as the UK's interest rates will remain elevated compared to those of the Eurozone.

Average prices charged by the UK's private sector firms increased at the steepest pace for nine months, led by a robust and accelerated rise in the service economy.

The Bank of England is particularly concerned about services sector inflation. It judges that headline inflation won't return to the 2.0% target until prices charged by the services sector retreat.

Survey respondents said they needed to raise prices to alleviate pressure on margins from higher salary payments, general business overheads, and higher fuel and raw material prices.

Chancellor Reeves will be concerned that the report revealed business activity expectations for the year ahead moderated for the fifth successive month in December; the latest survey pointed to the lowest degree of business optimism since December 2022, largely due to an ongoing slide in service sector confidence.

Service providers widely commented on rising costs due to increased employers’ National Insurance contributions and a subsequent need to adopt a more cautious approach to business expansion plans.

Although the report's details are downbeat, the Pound has risen against the Euro. This says more about the economic malaise in the Eurozone, where December PMIs confirmed the bloc's economy is in a worse position than that of the UK.

The Eurozone's Composite PMI read at 49.5, which is consistent with economic contraction.

S&P Global says output was scaled back amid sustained reductions in new orders, and the pace of job cuts was the fastest in four years as companies responded to a drop in workloads by lowering their staffing levels.