British Pound's Rally Temporary says Julius Baer Economist

Economists at a leading Swiss Bank believe the Bank of England will realise raising interest rates would be the "wrong medicine" for the UK economy, and the Pound's recent rally is therefore questionable.

Pound Sterling has surged higher after the September Bank of England policy meeting following indications the bank might raise interest rates in the near-future.

The rally has been impressive with the GBP/EUR exchange rate pushing up to 1.14 having started the week sub-1.10 and the GBP/USD exchange rate going up to 1.3586 having started the week closer to 1.31. 

But, the currency is destined to give back most of its gains says David A. Meier, an economist at Swiss bank Julius Baer.

Meier believes the Bank only said it was considering raising rates as a ploy to manipulate the Pound higher and in do so help curb inflationary pressures.

"We continue to be sceptical and believe that the hawkish tone was deliberately set to stabilise further the Pound Sterling," says the economist in a note dated September 15.

If it was the Bank's intention to give Sterling a boost, then there will certainly be some happy individuals down on Threadneedle Street as they certainly have delivered.

A higher Pound would help cool inflation as import costs are reduced; inflation was reported at 2.9% in this week's latest CPI report issued by the Office for National Statistics, well above the Bank's target at 2.0%.

On the release Stering jumped higher as markets bet that the rise would make the Bank uncomfortable, this bet has clearly paid off.

"Inflation is strongly driven by the Pound’s weakness, and while close to letter-writing territory at recent levels, the now stronger Pound will limit the inflation overshoot. It is less domestic overheating, which is causing the inflation surge, and rate hikes at this point would be the wrong medicine," says Meier.

Indeed, Meier points out that despite the very low levels of unemployment wages remain "sluggish", and it is this which is mainly responsible for curbing consumer's purchasing power.

But the Bank of England believe that with unemployment continuing to fall it won't be long before upside pressures are placed on wages.

Indeed, on Friday we heard from the Bank of England's Gertjan Vlieghe who told an audience that “if near-term Labour market trends continue, expect upward pressure on medium-term inflation."

Vlieghe who is one of the most cautious members of the Bank's Monetary Policy Committee came out and said interest rates should be raised soon. This caught markets by surprise and solidified the view that an interest rate rise is coming in November, the Pound gave us another growth spurt in response.

“There are some early signs of stronger consumption growth in Q3.”

But Julius Baer are wary that to raise interest rates in current conditions would only burden consumers with more financial demands via higher debt and mortgage repayments rather than easing their woes.

As such Meier thinks the BoE will rescind on their promise to hike rates in the near-term and Sterling will probably, therefore, roll-over and lose ground once this becomes obvious.

"We expect some sobering of over-eager rate expectations to soften the currency later down the road and stick to our bearish GBP outlook," he concludes.

But Meier risks being wrong on this count as Vlieghe observes, "there are some early signs of stronger consumption growth in Q3."

Julius Baer admit that as a result of the BoE meeting they do acknowledge a higher risk of a rate hike in coming months too:

"We acknowledge that there are now higher risks of a rate hike in the UK; in particular, the BoE has now leeway to sell a single rate hike as a reversal of the July 2016 post-Brexit emergency rate cut, which would nevertheless not be the beginning of a rate hike cycle."

Indeed, a 0.25% interest rate would merely reverse the rate cut enacted in 2016 when the UK boasted one of the fastest growing economies in the G10.

The Bank can afford to take the rate rise off the table and reinforce their rhetoric with action. They simply cannot afford to dodge raising rates if their credibility is to be maintained.