Pound Sterling: Bank of England Must Step Up with Big Hike says Capital Economics

Above: File image of Bank of England Governor Andrew Bailey. Image: Pound Sterling Live.

The Bank of England must take the initiative and hike UK interest rates significantly if the decline in the British Pound is to be arrested, says a leading economic research consultancy.

Capital Economics says the Bank must now "get on front foot with big rate hike".

The call comes in the wake of the Pound to Dollar exchange rate plunging to all-time lows against then Dollar on Monday, during a flash crash in the Asian currency market session.

The Pound has lost ground against all the world's currencies, with the Pound to Euro exchange rate dipping below 1.10.

At the time of writing the Pound is stabilising and recouping most of its flash crash losses.

But more must be done, says Paul Dales, Chief UK Economist at Capital Economics.

"The further fall in the pound in early trading means that we’ve now reached the point where the Bank of England needs to step in in order to regain the initiative. There are a couple of ways it could do this," he says in a note out Monday.

Dales says time is of the essence.

"Bailey could come out this morning emphasising the Bank’s commitment to the 2% inflation target and providing a clear signal that it intends to raise interest rates aggressively at the next policy meeting in early November," he says.

Pound in recovery mode

Above: GBP/USD (top) and GBP/EUR (bottom) at 15 minute intervals. To better time your payment requirements, set your FX rate alert here.

Dales says were this message coordinated with the government, "it could relieve some downward pressure on the pound".

For its part the government must maintain its commitment to long-term fiscal discipline and will bring forward plans to spell out how it intends to keep the public debt position stable following last week’s fiscal splurge, says Dales.

But the Bank of England is said to be more critical in arresting Sterling's declines.

"This would mean that Bank Governor Bailey has his 'whatever it takes' moment and credibility is restored. But we're not convinced that Bailey has enough credit in the bank to pull this off and November’s MPC meeting feels a long way away right now," says Dales.

Capital Economics is of the opinion, like many currency market analysts and economists, that the Bank of England has been too timid in raising interest rates.

Their argument is greater hikes must be delivered to make UK assets sufficiently attractive to foreign investors. Failure to do so demands a depreciation in the Pound to drive the valuation adjustment.

Shahab Jalinoos at Credit Suisse warned of the current crisis when he wrote ahead of last week's Bank of England interest rate decision.

He said the decision would be "perhaps most critical of all.

"Either it hikes by at least 75bp (and preferably 100bp) in order to start on the path of taking rates to levels high enough (5% plus in our view) needed to attract sufficient foreign capital to fund a very profligate government energy subsidy policy as well as already-high consumption rates, or instead it can continue on a cautious path of 50bp hikes and instead doom GBP to further losses," he said.

The Bank didn't, and the Pound cratered.

Dales says the Bank of England must now get "back on the front foot".

"That would be tough talk supported by a large and immediate interest rate hike that shows the markets the Bank is writing the script not responding to it. That could involve something like a 100bps or 150bps hike in interest rates (to 3.25%/3.75%)," says Dales.

"By bringing forward a lot of the policy tightening that might needed to have happened anyway, the Bank would demonstrate in no uncertain terms that whatever the government does it will ensure that inflation returns to 2%. This would go a long way to easing the crisis," he adds.

But Dales and his colleagues worries that even this might not be enough to rescue the Pound.

"We’ve entered the part of the currency crisis where psychology takes over," he says. "That could mean the markets continue to test the Bank and the pound falls further, suggesting that the Bank has to have another go to assert its authority."