By Mike Dolan

LONDON (Reuters) – Tight monetary policy combined with an austerity-driven fiscal plan usually results in currency appreciation, and sterling has been gaining on that front. But it is unclear why the U.K. government or the Bank of England would want the pound to rise now.

Many central bank watchers had said the BoE’s decision this week to hold off on its second rate cut this year would not happen.

But the freeze is more significant – and even a little puzzling – given what the BoE’s G7 counterparts have been doing – notably the Federal Reserve’s significant half-percentage-point rate cut the previous day and the European Central Bank’s second rate cut of 2024 last week.

Keeping the UK interest rate at 5% may simply be a matter of messaging, as the BoE seems to suggest.

It could be a signal to wage negotiators that they need to temper their expectations and a call for service sector firms to rein in still-high price increases. Or it could simply be a justified hesitation as the BoE awaits the difficult data it will receive in the first budget of a novel Labour government, due next month.

However, with the Bank of England’s repeated emphasis on eliminating the “persistence” of inflation, it has adopted a distinctly more hawkish tone than other major central banks in recent times – to the extent that markets now believe the chance of the Bank of England cutting rates in November is less than 70%, compared with something certain before the meeting.

And markets see an equally painful end to the UK’s monetary easing cycle.

The suggested “final rate” is currently around 3.4%, which the central bank aims to reach by the end of next year. That is almost 50 basis points higher than the Fed’s corresponding rate, 150 basis points higher than the ECB and Bank of Canada rates, and 300 basis points higher than the Bank of Japan rate.

All of these interest rates are higher than they were in the decade leading up to the global race to tighten monetary policy in 2022.

It’s not entirely clear what the rationale is. Are the UK’s underlying inflationary pressures really that much worse than those in other major economies today? Has the UK’s historical vulnerability to inflation reared its ugly head again? Or has Brexit thrown a spanner in the works in the works?

The longer-term horizon of market interest rates also appears puzzling when we consider other details of the central bank’s outlook.

In its statement from the meeting, the BoE cut its GDP growth forecast for the current quarter, said services inflation would fall further by the end of the year and noted that surveys showed public inflation expectations were falling to pre-pandemic levels and that core inflation was approaching its 2% target.

The economic fallout should be larger if the government’s next budget follows early indications and tightens fiscal policy with a combination of tax rises and spending cuts needed to plug a widely touted £20 billion ($26.55 billion) hole in the public finances.

STERLING IN THE LEAD ROLE

Sterling clearly loves it. The promise of relatively tight monetary and fiscal policies has pushed the pound to its highest level against the dollar in more than two years. And that’s just a hair’s breadth from two-year highs against the euro.

The trade-weighted sterling index has risen more than 3% this year and is within striking distance of its highest level since the 2016 Brexit referendum.

Given that Brexit’s trade woes are at least part of the UK’s growth woes, a rising pound is unlikely to be much aid at the moment.

Even if a robust pound puts downward pressure on imported energy or commodity inflation, that is unlikely to aid the BoE. Its stated concerns are domestic services and wages, which are largely unrelated to the exchange rate.

The BoE noted that the effective exchange rate of the pound had risen by more than 1% since its previous meeting, although it blamed this on changes in the US exchange rate and the associated move in the dollar.

‘IDIOSYNCRATIC’

If it is only a matter of time, the Bank of England will eventually have to accelerate its monetary easing, and some economists think that will happen.

“If the government becomes more stringent on fiscal policy, we believe the Bank will be forced to accelerate the pace of the cuts cycle to offset the losses suffered by households and businesses,” said AXA Investment Managers economist Gabriella Dickens, adding that there was a tiny probability of two cuts by the end of the year.

And the central bank may have a lot of catching up to do.

Jefferies economist Modupe Adegbembo said that while there may be “specific” reasons for the persistence of UK inflation, the pressure on the BoE to deliver two more rate cuts this year would escalate significantly if the Fed eases monetary policy by another 50 basis points at its next meeting.

So the pound may have good reason to be where it is now, but that strength could evaporate quickly if it relies solely on such a high BoE target zone.

The views expressed in this article are those of the author, a columnist for Reuters

(1 dollar = 0.7534 pounds)

(Author: Mike Dolan; Editing: Jamie Freed)