Of all the variables that impact the performance of exchange rates, one is emblematic of their ability to pull the markets back and forth: interest rates. This has been amplified by a surge in borrowing costs across the globe to cool persistent inflation. As a central bank’s main weapon in the battle against rising consumer prices, interest rates have been making headlines in the UK, US and EU.
Let’s explore how soaring inflation has triggered aggressive monetary policy measures, how rising rates have impacted the pound, what happens next, and what it means for business with foreign exchange (FX) exposure.
Rate hikes: the battle to cool inflation
The UK’s economic malaise heated inflation up to 11.1% in October 2022 – a red-hot 41-year high – amid a struggling post-pandemic jobs market, state energy subsidies and a reliance on natural gas for heating and electricity. This was compounded by Russia’s invasion of Ukraine in February 2022, which sent natural gas prices soaring across Europe.
Bank of England (BoE) rate-setters had already sprung into action in December 2021 to stem the tide. Relying on the theory that raising interest rates slows down price rises by making it more expensive to borrow money, meaning people have less to spend, the central bank embarked on a series of 14 consecutive increases – a prolonged hiking cycle that lifted the Bank rate from a record low 0.1% to 5.25% by August 2023, its highest level for 15 years.
It’s been a similar story in the US and EU where inflation soared to a 40-year high of 9.1% in June 2022 and a peak of 10.6% in October 2022 respectively – prompting the Federal Reserve to lift rates to multi-year highs and the European Central Bank (ECB) to take them into uncharted territory.
Impact on the pound
Generally, higher interest rates increase a currency’s value. That’s because they attract more overseas investment, which means more money coming into a country and higher demand for the currency. Last year saw this theory play out for the pound against the dollar and the euro.
When Liz Truss and Kwasi Kwarteng’s disastrous tax-cutting mini-budget sent the UK economy spiralling into a debt crisis in autumn 2022, the pound slumped to almost parity with the dollar. Despite enduring weak economic growth and falling productivity in 2023, the pound recovered to become the strongest performing currency among the G10 leading economies in the first half of the year – climbing above 1.31 against the dollar in July, its highest level in 15 months, and 1.17 against the euro, it’s highest level in 11 months.
It’s no coincidence that this upward trend, culminating in multi-month highs, coincided with aggressive policy tightening from the BoE; or that a subsequent fall in value followed a pause in the rate hiking cycle.
Having peaked in October 2022, a steady decline in the rate of inflation towards the BoE’s 2% target meant the central bank had achieved one of its goals: halving the consumer price index (CPI) measure of inflation by the end of 2023. This prompted it to put its most aggressive hiking cycle in decades on hold in September – following in the footsteps of the Fed and a month ahead of the ECB. The immediate impact on the pound was telling: with the brakes applied to its driving force the UK currency skidded to a six-month low, dropping by as much as 0.9%.
Lingering interest rate tailwinds helped the GBP-USD exchange rate regain its momentum in the final quarter of 2023. In November the pound surged against the dollar after the BoE struck a hawkish tone. As expected, the central bank held borrowing costs steady, but three of its nine rate-setters voted for a hike – an outcome that showed the decision between holding or hiking was finely balanced. The pair ended 2023 by hitting a more than four-month high as increased bets the Fed will slash interest rates in 2024 and a surprise drop in UK inflation combined to send it higher.
Contrasting interest rate expectations on either side of the English Channel helped the GBP-EUR exchange rate to gain traction at the start of 2024. The pound was boosted in mid-January by warming inflation after the CPI unexpectedly rose from a two-year low to 4%, beating economists’ forecasts that it would cool to 3.8%. Rate cut expectations were dampened by the print, causing the pound to surge.
Meanwhile, the euro felt the weight of investor speculation that weak economic performance in the EU spells a loosening of restrictive monetary policy measures. Soaring ECB rate cut bets propelled the pair to a six-month high in the 1.17 mid-range on 29 January.
Central banks: what next?
Interest rates have been on hold in the UK since September but borrowing costs remain historically high – and it’s a similar story in the US and the EU. So, will they fall in 2024?
Bank of England
The BoE has continued to hold interest rates at 5.25% in 2024 to keep a lid on inflation, despite mounting recessionary fears. Running at 4% in December 2023, down from a peak of 11.1% in October 2022, inflation was still twice the central bank’s target, which it’s expected to reach by spring – so when will rates start to fall?
The BoE has the unenviable task of balancing the need to slow price rises against the risk of damaging the stagnating economy by keeping rates elevated. Governor Andrew Bailey said it would wait for firm evidence that inflation was under control before it begins cutting rates. Despite a small uptick in December, the CPI dropped significantly during 2023. With wage growth slowing more than expected and the economy stalling, speculation is rife that the BoE will start trimming rates sooner.
According to forecasts from Capital Economics, the BoE will cut the base rate to around 3% by late 2025 – which is more optimistic than the 3.5-3.75% priced into the market. The economic researcher has pencilled in the first rate cut for June this year, while investors are pricing in four or five cuts in 2024, with the first coming in May.
Federal Reserve
A month is a long time in economics. In December, the Fed held its key interest rate steady for the third straight meeting and set the table for multiple cuts in 2024 and beyond – a dovish stance that prompted financial markets to anticipate more than a 73% chance the Fed will start lowering rates at its March meeting.
Fast-forward a few weeks and this view had been slashed to about a 34% chance. Fresh economic tailwinds confirmed the view of Fed policymakers that there is no rush to begin lowering interest rates.
In remarks after the announcement to leave rates unchanged for a fourth straight time in January, Fed Chair Jerome Powell said he thought it was unlikely that the first post-pandemic cut would come in March. Inflation, he said, remains too hot at 3.4%, with the central bank aiming for its 2% target.
With a March rate cut off the table and the chances of one in May fading, it is unlikely there will be a major change in US borrowing costs anytime soon.
European Central Bank
The interest rate outlook in the EU varies depending on who you listen to. According to a Bloomberg poll of economists, the ECB will lower rates four times in 2024, kicking off in June, as inflation retreats more quickly than previously forecast.
Meanwhile, the central bank recently reaffirmed that it’s too soon to discuss a reversal. Speaking after holding interest rates at a record-high 4% in January, ECB President Christine Lagarde said “The consensus around the table was that it was premature to discuss rate cuts…We need to be further along the disinflation process to be confident that inflation will be at target – sustainably so.”
What should businesses be prepared for?
As we transition from a period where it wasn’t a case of if policy will be tightened but by how much to when will interest rate policy loosen and how quickly, what should businesses with FX exposure expect?
The BoE lowered the interest rate in 2009 in the wake of the global financial crisis, in 2016 following the surprise Brexit vote and in 2020 after the pandemic blindsided society. Generally, lower interest rates increase a currency’s value. However, the immediate impact of these historic borrowing cost cuts underscores that businesses must prepare for every eventuality:
- The pound strengthened in January 2009 after the BoE cut rates to a then-record low 1.5%.
- The pound fell sharply against the dollar and euro in August 2016 after the BoE cut interest rates for the first time in more than seven years.
- The pound initially rose in value in March 2020 after the BoE cut interest rates to an all-time low of 0.1%, before falling back against the dollar.
Without the luxury of a crystal ball, you can’t be sure when central banks will begin loosening monetary policy or how it will impact the currency markets. Rather than relying on potentially inaccurate economic forecasts, it’s prudent to plan for all outcomes or risk your profit margins being squeezed by a sudden drop in the value of the pound.
At Lumon we understand that every business has unique business needs and risk appetite, meaning there’s no one-size-fits-all approach to protecting profit margins from FX risk. To instil the agility needed to proactively manage market uncertainty, we will help you develop a tailored hedging strategy that aligns with the level of risk you’re exposed to and seeking protection from. The flexible solutions that underpin this empower you to leverage currency market volatility by securing exchange rates for future transactions – providing certainty and stability in your financial planning.
