The pound has surged to a one-year high against the dollar as traders drastically scaled back their expectations of an interest rate cut by the Bank of England next month.
Sterling rose by 0.45% to $1.30, its highest level since July 2023, following the release of official figures showing that inflation in the services sector remained steady at 5.7% in June. Additionally, annual consumer price inflation held at 2%, meeting the Bank’s official target, while more persistent measures of inflation did not decline as economists had anticipated.
In response to the sticky inflation data, traders reduced the likelihood of an August 1 interest rate cut from 50% to 25%. Earlier this month, financial markets had assigned a 70% probability to the Bank’s first rate cut in four years.
Investors reacted by buying the pound and selling UK government bonds, which are particularly sensitive to interest rate expectations. The yield on two-year gilts rose by 6.5 basis points to 4.01%, while ten-year gilt yields increased to 4.08%, reflecting higher government borrowing costs. Bond yields rise as prices fall, and currencies typically strengthen in a higher interest rate environment.
Despite no change in services inflation, the Office for National Statistics noted a 1.4% annual decline in goods prices, driven by reduced costs for furniture, household items, and clothing, largely due to summer sales amid poor weather. Food price inflation has also decreased from over 17% last year to 1.4%, the lowest since October 2021.
Economists suggest that the monetary policy committee (MPC) members will now be more cautious about cutting interest rates, given that services inflation is 0.6 percentage points higher than the Bank’s forecasts. Recent growth statistics showing the UK economy expanding at its fastest rate in two years further complicate the case for monetary loosening.
“Services inflation and wage growth remain high,” said Sonali Punhani, UK economist at Bank of America. “The persistence of domestic inflation suggests that any rate-cutting cycle will likely be slow and shallow, with fewer cuts than our base case of two this year and four next year.”
Economists predict that the headline inflation rate could increase from 2% in the coming months as energy prices rise following a significant drop last year.
The MPC is set to meet on August 1 to decide on interest rates and will also release updated economic growth and inflation forecasts.
Gabriella Dickens, economist at Axa Investment Manager, mentioned that the nine-member MPC could still vote five to four in favour of reducing the base rate from 5.25% to 5% next month. A shift would require support from Governor Andrew Bailey, his deputies Sarah Breeden and Clare Lombardelli, and the two MPC members who backed a rate cut in June, Sir Dave Ramsden and Swati Dhingra.
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Pound surges as interest rate cut expectations fade