Serious possibility of raising interest rates

Wednesday 05th July 2017 09:37 EDT

All eyes were on Britain’s election at the start of the month with many polls predicting a wide range of outcomes - from a slim majority for the Conservatives to a hung parliament. In addition, forecasts for UK economic growth were optimistic in early June.

As polling day approached, markets began to anticipate a Conservative majority which buoyed the pound. However on the evening before the election, the pound plummeted as exit polls revealed the prospect of Theresa May’s Conservatives falling short of a majority and a hung parliament looking increasingly likely.

Overnight, this expectation became a reality as the Conservatives had won only 313 seats and were therefore no longer able to reach the 326-mark needed to command a parliamentary majority. This was a shockingly bad election result for May who was fighting to hold on to her job on Friday as British voters dealt her a punishing blow, denying her the stronger mandate she had sought to conduct Brexit talks and instead weakening her party's grip on power.
The surprise result raised questions about how Britain will advance with its plan to leave the European Union, and whether any party can form a stable government. The pound initially sank the pound by 2 percent against both the dollar and euro. The result bought humiliation for the Conservatives with May finishing with fewer seats than when she called the election.

In the aftermath of the election, May said she would form a government backed by the DUP which is a small Northern Irish party, days before launching talks on Britain's EU departure. The result raised questions about how Britain will advance with its plan to leave the EU. It sent the pound to eight-week lows against the dollar and its lowest levels in seven months versus the euro.

However the pound began to strengthen in the week after the election after the UK’s inflation rate hit a four year high, pushing up to 2.9%. Three members of the Bank of England's policy committee then surprised financial markets by voting for a rise in interest rates. As a result, sterling surged to its highest level in a week against the euro. At a time when the BoE has blamed a rise in inflation past its 2 percent target on a weak pound, traders read the split vote as warning that officials could seek to defend the currency with rhetoric or action, even as the economy overall slows.
The rally in the pound was short lived compounded dovish intervention from Mark Carney in an increasingly heated debate over interest rates within the Bank of England. Mr Carney urged caution in any shifts to monetary policy due to concerns of a slowdown in consumer spending and disappointing wage growth, causing sterling to drop to its lowest level since Theresa May called a snap election in mid-April.

On June 27, May struck a deal to prop up her minority government by agreeing to at least £1bn in extra funding for Northern Ireland in return for the support of the DUP giving her the parliamentary numbers to pass a budget and a better chance of passing laws to take Britain out of the European Union

However later in the month, the BoE Governor indicated that higher interest rates will be "necessary" if UK businesses shrug off Brexit uncertainty and raise investment and wages against a brighter global backdrop. As a result, the pound surged against the dollar and euro. These comments came as a surprise to markets as earlier this month Mr Carney said now was "not yet the time" to start raising rates as he warned that the "reality of Brexit negotiations" were yet to hit the economy.

The rally in sterling was further exacerbated by further hawkish comments from BoE chief economist Andy Haldane saying "We need to look seriously at the possibility of raising interest rates to keep the lid on those cost of living increases, for now we are happy with where the rates are, we need to be vigilant for what happens next".
The dollar strengthened later in the month after US Federal Reserve raised its headline interest rate by 0.25 per cent on June 14. As widely expected Janet Yellen announced plans to raise the target range for the federal funds rate to between one and 1.25 per cent. In the run up to the decision markets priced in a near 100% chance of a hike. The Federal Reserve expect that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate, after their fourth upwards move in the federal funds rate since before the financial crisis.

 On June 28, the Euro rose to hit a 10 month high against the dollar after a hawkish speech by ECB chief Mario Draghi at the ECB forum in Portugal yesterday. The euro's rally came after Draghi praised the eurozone's economic recovery on the back of positive data and said that deflationary forces had been replaced by reflationary ones.

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