John Fahey: Risks of UK stagflation appear to hinder further gains for sterling

Sterling has benefitted from widening interest rate differentials, as the Bank of England continued to hike interest rates.

One of the biggest surprises over the first half of 2023 has been the strength of sterling, the currency having made gains against other major currencies, including the dollar and the euro. 

The magnitude of the gains has been in the order of 4% to 5%, which is reflected in the pound having fallen to 88 pence and then for it to trade at near to 85 pence since mid-June. 

Meanwhile, the stronger tone to sterling was also evident, with the currency moving up from $1.18 against the dollar in January to almost $1.28 in the past month.

One reason for sterling’s strong performance is that the UK economy has been better than expected. However, the UK economy has stagnated rather than contracted and its GDP has essentially flat-lined since the second quarter of last year.

At the same time, sterling has benefitted from widening interest rate differentials, as the Bank of England continued to hike interest rates. 

British inflation has persisted at elevated levels compared with elsewhere: Its headline rate of consumer prices of 8.7% in May compares with 4% in the US and 5.5% in the eurozone. 

Core inflation

Meanwhile, core British inflation unexpectedly rose to 7.1%, leading to a marked firming in UK rate expectations over the last few months.

However, the reaction of sterling to the most recent Bank of England policy announcement in June is noteworthy. At this meeting, the bank provided a surprise by hiking by 50 basis points rather than the expected quarter point rise. Yet, sterling did not register any gains following the more aggressive rate increase. 

UK rates are now expected to peak at 6.5% early next year, up from 5.5% previously. In contrast, eurozone rates are seen topping out about 4%, while the market envisages the US Fed funds rate will reach a high of 5.5%. 

Historically, rate increases are a positive for a currency, when they coincide with ongoing economic growth. However, continued rate increases amid a stagnant or contracting economy, alongside elevated levels of inflation, tend to play out negatively for a currency.

It appears to be the case that stagflation risks in the UK are now hindering any further upward momentum for sterling from additional rate hikes. 

At the same time, positioning data shows the market is very long on the currency. Therefore, sterling could struggle to make further gains during the second half of this year. Indeed, 83 pence to 84 pence has been the floor since the Brexit referendum in June 2016.

• John Fahey is senior economist at AIB