Is now a good time to buy the British pound? Fundamentals point to caution

By:
on Aug 31, 2022
  • The Bank of England faces a tough time normalizing the policy due to macroeconomic challenges
  • Inflation in the United Kingdom exceeds 10% while wage growth rises as well
  • The British pound remains weak and the trend is set to continue towards the end of the trading year

The COVID-19 pandemic has triggered a wave of unprecedented measures from both central bankers and governments. By stimulating economic activity and supporting households, the measures did help.

In hindsight, it isn’t easy to imagine otherwise. But it all came at a cost.

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That is, unsustainable inflation.

Inflation in the advanced economies has spiraled out of control. In the United Kingdom, it has reached the double-digit territory.

The disconnect looks surreal. The Bank of England fights 10.1% inflation with 1.75% interest rates.

At the same time, it targets 2% inflation.

But why doesn’t the Bank of England raise the rates more aggressively?

The Bank of England’s challenges in normalizing policy

The Federal Reserve of the United States has embarked on an aggressive monetary policy tightening cycle to fight rising inflation. But the Bank of England, just like the European Central Bank, cannot do the same.

The macro picture looks increasingly complicated in the UK for at least several reasons.

First, there is a labor shortage while inflation is above 10%. In other words, wage pressures will further fuel inflation, and the current bank rate level is not enough to offset the rise in the prices of goods and services.

Wage growth has reached 5% in the UK.

Second, the record trade deficit and negative productivity are direct consequences of Brexit. It is still early to evaluate the full impact Brexit has on the UK economy, but the two are clear indicators that the path is not the right one.

Third, there is talk of fiscal stimulus ahead, which will further contribute to the rise in the prices of goods and services.

Finally, high European energy prices have a direct impact on UK households.

Faced with such a set of macro variables, the Bank of England has a hard time fighting inflation. This is why it has warned in the past that by the end of the year inflation will be well into double-digit territory.

As a result, the British pound is one of the weakest currencies on the FX dashboard. In fact, it trades like an emerging currency, dropping even against the euro.

In 2022, the common currency, the euro, lost more than 12% against the US dollar. At the same time, the EUR/GBP cross gained 2.34%.

The combination of the two implies that the British pound lost even more against the US dollar. Moreover, its inability to gain against the euro is striking.

After all, there is a war in Eastern Europe, one affecting more the euro area economies than the UK economy.

All in all, fundamentals point to further weakness for the British pound, as the challenges the Bank of England faces are unlikely to go away anytime soon.

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