The UK Series: The BoE's dilemma 4/6

24 September, 2013

The UK battles with extremely stubborn levels of inflation, leaving family incomes particularly stretched. The price of living has increased but wage appreciation has been minimal.

The pressure is on the BoE to increase their benchmark lending rates. This would show renewed confidence in their economy, and partly subsidise higher living costs.

Still, the BoE needs to be careful. If they increase lending rates too soon, it could be disastrous for the recovery of their economy. An increase in the sterling may also overprice exports, something that is crucial to the UK GDP.

This brings us to the question: What exactly can the BoE do?   

Inflation

Inflation is no longer as uncontrollable as the previous 5.1% levels would suggest, with the latest inflation reading being 2.7%. This is still some distance away from the BoE’s longer term 2.0% target.

Although progress has been made on lowering the inflation levels, they still present negative consequences for the UK consumer. It was recently announced by the Office for National Statistics (ONS) that disposable income within the UK is now at a 10 year low.

It may take some time for the inflation levels to reach 2%, but there is optimism that the inflation levels will steadily decrease throughout the next quarter. As inflation lowers, consumer confidence will grow. This will lead to an increase in consumer spending and boost the economy, resulting in an upturn for the cable.

Interest rates

The BoE increasing their interest rates would lead to a huge vote in confidence for the UK currency. This would be universal news, especially with other economies, like the US and EU performing indifferently. Australia and New Zealand feel their currency is over-valued and are looking at methodologies to devalue their currency.

An increase in interest rates could lead to a perennial influx of overseas entities expanding into the UK market. This would surely boost the UK employment statistics, giving the cable a sharp boost.

The Likely Scenario

It is most likely the BoE will maintain their current monetary policy.

To say that there is enthusiasm and growing confidence about the UK economy would be an understatement. However in truth, the recovery is just beginning. Chancellor George Osborne validated this sentiment recently by stating that ‘Britain is starting to turn the corner’. There is still very much an air of caution not just with regards to the recent impressive economic results, but also towards replicating these standards in the future.

Unemployment is still high in the UK, which is preventing the BoE from raising their lending rates. Mark Carney is adamant that he will not even consider increasing the lending rates until unemployment hits a ‘threshold’ level of 7%. He even reiterated that this benchmark is clearly a ‘threshold’ and does not indicate an impending change in interest rates. It is quite possible that this reluctance could prevent the cable from reaching its full potential.

However, one thing is for certain, the UK has been commendable in improving its economy. Growth is being shown in all the required areas, with indications suggesting the growth is sustainable. This alone will play an integral factor in increasing employment opportunities.

It is inevitable that at some point, the unemployment rates will fall below 7% and the pressure on the BoE to increase the rates may become too hard to resist. In the meantime, US data is inconsistent and there are fresh worries over when the Federal Reserve will begin exiting QE. If this is the case, longing the GBPUSD is a very appealing option.   

Written by Jameel Ahmad, Research Analyst at Blackwell Global.

Follow Jameel on Twitter @JameelAhmadFX


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