The Bank of England is caught between poor economic growth and the threat of inflaiton overshooting its 2% target.
Sterling has been falling all week. Since Monday (29 July), the pound has steadily depreciated against the dollar falling below $1.21 on Thursday morning (1 August) for the first time since January 2017. Measured against the euro, the pound has slumped to its weakest level in a decade, dipping below €1.10.
Behind this currency volatility is fear of one thing: a no-deal Brexit. While UK assets have been struggling in general ever since the referendum (alongside growing fears of a Corbyn-led Labour government), new prime minister Boris Johnson has spooked markets into believing he could lead the UK out of the European Union without a deal.
Generally, that’s good news for the FTSE 100. The blue-chip index managed to close 1.26% up in July, partly on the back of the earnings boost a strong pound brings companies that derive their earnings from abroad (which count for about 70% of the FTSE 100). The index, however, has since given up much of those gains.
Looking further out a persistently weak pound leads to higher levels of inflation. This is because as the value of the pound depreciates against other currencies, the cost of importing certain products rises. These cost increases are then passed on to consumers.
According to textbook theory, this would result in the Bank of England step in a raise rates. As Ben Kumar, investment strategist at Seven Investment Management, notes: “For the Bank of England, under normal circumstances, recent strong wage growth data and the recent sterling weakness would suggest that the Monetary Policy Committee should raise interest rates.”
This would, in theory, help to push the value of the pound up, offsetting potential import inflation.
But instead the Bank opted, in its latest policy announcement, to keep rates a 0.75% - despite forecasting inflation being above its target rate of 2% in the next two to three years.
But there was good reason for this: UK economic growth is slowing, as is the global economy. According to Charles Hepworth, investment director at GAM: “Hiking rates in the face of a slowing domestic environment is not an option.”
This has put the Bank of England in a bind. As Oliver Blackbourn, multi-asset portfolio manager at Janus Henderson, notes: “The Bank appears to be caught between a weaker near-term growth outlook and expectations that inflation will rise above the 2% target over the next three years.”
Added to this, the Bank still has to navigate the fallout of a potential no-deal Brexit. While this could see the currency further weakened, it may feel compelled to lower rates to support growth.
In the meantime, notes Phil Smeaton, chief investment officer at Sanlam: “[Bank governor] Mark Carney continues to keep his powder dry, hoping for a surer footing. But a cut by the end of the year looks almost certain.”