Bank of England Must Raise Rates, Inflation to Hit 2% in 2016

The British pound has under-performed most currencies over recent days as expectations for the first interest rate in the upcoming cycle expected to be delayed.

The pound to euro has fallen from 1.44 when rate expectations were pricing in an early 2016 hike down to the 1.36’s as markets push back expectations for a rate hike to August.

The pound to dollar saw 1.58 at the start of the week and now a pound can only buy 1.5370 dollars on the open market.

"Excellent value for the GBP buyer with sterling at seven-week lows and on track for its worst week since the spring. The latest global market turmoil has dealt a setback to expectations that area interest rates could rise sooner rather than later," says Joe Manimbo at Western Union. 

Also weighing on the GBP is a change in inflation expectations in the wake of a further decline in commodity prices, with the two-year breakeven inflation rate falling by almost 0.2 percentage points over the last week (and 0.5 points in the last two months).

While markets take a nonchalant view of UK rate expectations they have meanwhile been growing more confident in the US.

This is ironic as it is almost universally acknowledged that a rate rise in the US will open the door to a rate rise in the UK as the Bank of England tends to follow the Federal Reserve in policy moves.

Thus, our instincts are that the weakness seen in the pound sterling strip is overdone.

“Whilst there may be good reasons for believing the BoE will postpone the timing of the first hike, it is questionable whether it needs to do so,” argues Peter Dixon at Commerzbank in London.

For one thing, suggests Dixon, the direct impact of a Chinese economic slowdown on the UK is likely to be limited – over the past four years exports to China have contributed less than 0.1 percentage points per year to UK GDP growth.

“Moreover, the case for postponing monetary tightening to support a market which has been boosted by a lax monetary stance is weak,” says Dixon.

It was confirmed on the 28th of August that Britain's economy grew 0.7 pct in the second quarter of this year. Interestingly, it was noted that the underlying data shows welcome rebalancing in the economy towards investment and exports.

Exports showed an unexpectedly sharp rise of 3.9 cpt - despite a glut of gloomy surveys suggesting manufacturers are struggling due to the strength of the sterling, as well as a slowing global economy.

The time to raise is now and we believe exchange rate markets are under-pricing the upside risks in the British pound. 

Inflation at 2% in 2016

Highlighting just why delaying rate rises could be dangerous is The Warwick Business School Forecasting System (WBSFS) which has revised upwards the probability that inflation will return to around its two per cent target level in 2016 following the UK's revised second quarter remaining at 0.7 per cent growth.

The WBSFS now forecasts there is a one-in-two chance the target of around two per cent will be achieved in 2016, as it calculates only a one-in-ten chance of deflation in 2016 rather than the one-in-two chance forecast a quarter ago.