Sterling passed a five-year high versus the dollar earlier this month before weakening in the wake of the Bank of England’s (BoE) latest inflation report.
Governor Mark Carney announced largely unchanged growth and inflation forecasts, disappointing expectations that the UK’s first interest rate hike in seven years may happen as early as January 2015.
‘Although the margin of spare capacity has probably narrowed a little since [February], the Monetary Policy Committee continue to judge there remains scope to make greater inroads into slack before raising the Bank rate,’ said the report.
The pound lost 0.5% against the dollar in minutes after the announcement and, despite recovering, the psychologically important 1.70 against the Greenback – not seen since August 2009 – has slipped back out of reach.
This comes after a 13% rise in the currency over the past 12 months, buoyed by improving economic indicators as the recovery gathers pace.
Richard Nehme, dealing director at International Foreign Exchange (IFX), said: ‘While the recent 10% surge in the UK housing market is stoking concerns of a housing bubble, retail sales growth and consumer price inflation remain weak.
‘The BoE could move to tame housing market inflation by scaling back its Help to Buy scheme and imposing mortgage restrictions rather than tightening policy. So in reality, if these areas of the UK economy continue to show some slack, it is understandable Carney does not want to increase rates any earlier.
‘From here, sterling looks fair value. We hope to see it hold ground, while any large recoveries will need to be helped by better-than-expected economic data due to be announced later this month.’
Prior to the inflation report, sterling had also increased to a 16-month high against the euro and Capital Economics believes recent strength has further to run.
Assistant economist Jack Allen said sterling’s appreciation against the euro over the past year was based on expectations the BoE would raise rates sooner than the European Central Bank (ECB).
‘Although sterling is now around its strongest level against the euro since last January, based on the relative outlook for monetary policy, we think it has further to rise,’ he said.
‘As long as house price rises can be contained by the Financial Policy Committee, the first interest rate hike will come in the second half of next year, slightly later than is currently priced into the market.
‘Meanwhile, it looks increasingly likely the ECB’s next move will be to loosen monetary policy. It has two ‘contingencies’ for further action – a worsening of the medium-term inflation outlook and unwarranted tightening in money markets – which have either been met or are on the brink of being met.’
Allen said European inflation might have risen in April, but it did so by less than expected and the trend was still down.
‘The ECB’s balance sheet continues to contract as banks repay funds borrowed at earlier long-term refinancing operations,’ he added.
‘It is not clear conditions have worsened enough for the bank to announce further easing this month, but we suspect it will not be too long before it does so.’