November rate expected by Investec who upgrade forecasts for Pound Sterling in response.
Bank of England policymakers were not bluffing with their latest warning of higher rates to come say Investec economists as they update their forecasts for UK interest rates and the value of Sterling over coming weeks and months.
Economists at the bank now see the Bank's Monetary Policy Committee raising interest rates in November which will have necessary implications for Sterling projections.
“Unless the UK is hit by a negative demand shock over the next six weeks, we view the prospect of a 25bp increase in the Bank rate to 0.50% in November as our new baseline case,” says Philip Shaw, chief economist at Investec. “This would represent the first hike since July 2007, when the Bank rate was increased by 25bps to 5.75%.”
Although there are a litany of Brexit-related risks for Sterling to navigatein the short-term, Shaw and his team say the Pound is fundamentally cheap and its recent levels already factor in a degree of turbulence from the process of leaving the EU.
“One theory doing the rounds is that the MPC is bluffing,” notes Shaw. “We do not subscribe to this view. The MPC’s latest prognosis has not come out of the blue. Indeed its concerns over tight labour markets and the prospects for inflationary pay increases have been evident since the spring.”
The Bank of England’s Gertjan Vlieghe noted last week that UK wage inflation could start accelerating on the back of pay growth noting, “if near-term Labour market trends continue, expect upward pressure on medium-term inflation. There are some early signs of stronger consumption growth in Q3.”
UK inflation reached 2.9% in August, according of Office for National Statistics data, threatening the 3.0% threshold where Governor Carney will have to write an open letter to HM Treasury setting out the bank’s plan to return it to the 2% target.
Eyeing heating inflation trends, the September Monetary Policy Committee meeting minutes said most policymakers expect to vote for a withdrawal of stimulus over the coming months if inflation continues to overshoot its target.
But, “we do not share the BoE’s angst over pay growth. This is almost incidental, but it is feasible that inflation declines faster than the MPC expects next year or that the rise in Sterling begins to choke off price pressures from overseas,” says Shaw.
September’s MPC statement was followed in quick succession with separate speeches from Mark Carney and Vlieghe, the bank’s most “dovish” policy maker, with both underlining a consensus on the committee that the time for action to raise rates could be near.
But there are concerns of the negative impact an interest rate might have.
"It is even possible that the economy reacts negatively to a move later this year and the MPC reconsiders its strategy further ahead” says Shaw. Concluding; “Indeed what was already a complex outlook for the British economy and markets has just become cloudier still."
Yet these concerns might be erring on the side of over-caution as the Bank of England argues that in 2017 financial conditions are exceptionally loose - i.e. the cost of borrowing is cheap. It is pointed out that a 0.25% rise in interest rates would still leave conditions more accomodative to borrowers than prior to the 0.25% rate cut of August 2016.
Pound Forecasts Upgraded
Despite the uncertainty expressed by Shaw, the new approach on rates adopted by the Bank of England leads Investec to nudge higher their forecasts for the British Pound.
"We suspect that most although not quite all of the news is priced into the UK currency," says Shaw.
While the upgrades are marginal, they are upgrades nevertheless.
Investec's new Pound-to-Dollar exchange rate forecast targets 1.38 by the end of 2017 and 1.40 for end-2018. This is up from 1.30 and 1.32 respectively.
The Pound-to-Euro exchange rate forecast is upgraded to 1.15 for both timeframes having been at 1.1360 and 1.11 previously.
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Also seeing the potential for further, albeit modest gains, in Sterling are Deutsche Bank who say they are looking to see the current rally in the Pound run further.
In the wake of the previous week's Bank of England update, Oliver Harvey at Deutsche Bank says the September meeting “was even more hawkish than we expected and we have subsequently changed our rate call for a hike in November. With this still less than 100% priced, and given the build up in short positioning over recent weeks, we wouldn’t fade the rally in GBP just yet," says Harvey.
Harvey also notes the Pound to still be undervalued relative to the Euro when interest rate differentials are accounted for.
“Medium-term, the structural Sterling outlook will depend on whether the recent improvement in the external balance is sustainable, whether UK growth can tolerate the Bank of England hiking and the timing of a Brexit deal."
Major question marks remain on each of these issues.
"But in the short-term at least, we think the move higher in GBP has further to run," says Harvey.