Focus on the Pound

As there is very little data of interest due out today, we focus on the UK economy and the possible influences on the Pound for the rest of 2014.

Last year, the Bank of England gave fairly firm indications that UK interest rates would start to rise once unemployment fell below 7%. Since interest rates are one of the most influential drivers of exchange rates (with higher interest rates usually meaning a stronger currency and better exchange rates), the Pound had started to react to unemployment figures, with sequential falls in UK unemployment pushing the Pound up towards recent highs, particularly against the US Dollar and Euro.

The problem is, the fall in unemployment has come too soon for the Bank of England. It now looks like the 7% target will be broken in the coming months, not late 2016 as first predicted. On Friday, Mark Carney effectively scrapped the link between interest rates and unemployment, saying that the economy had not yet reached “escape velocity” and was not ready for interest rate rises – and the Pound accordingly fell back around a cent against the Euro.

Inflation has also fallen more quickly than anticipated, which further reduces the pressure on the Bank to increase interest rates.

So what next? The Bank of England does have other tools available to help avoid another house price bubble – for example controlling the cost of bank credit via its Financial Policy Committee, or even reversing its £375bn QE programme – although the latter is something of an unknown quantity and is likely to happen after bank credit control and interest rate rises. Mortgage lending has risen by over 30% in the last year and, according to Nationwide, house prices increased by 8.4% in the year to December – and nobody wants to see the economy fail again if there is a boom and bust cycle in housing.

For now speculation about interest rate rises in the press should have been dampened – and that leaves the Pound vulnerable to falling back from recent gains which have been fuelled by exactly that speculation.

On the other hand the UK economy is now one of the fastest growing in Europe, and Mark Carney’s arrival at the Bank of England has coincided with a turnaround in fortunes for UK plc. It seems for now we can enjoy better exchange rates for those of you sending money abroad, but as always the medium term future is not as simple as it might seem – a recovering economy is good news for the Pound, but the Bank of England need to make sure that there is not a runaway success followed by another crash, and with higher interest rates still some way off, the Pound could be left higher than we might expect in the short term.