(Alliance News) - The pound could be facing pressures on both economic and political fronts as the Bank of England warned over a possible recession and the leadership over who will be the next UK prime minister remains uncertain.
BoE Governor Andrew Bailey on Thursday insisted controlling rampant inflation is the "absolute priority" as policymakers delivered the biggest hike in interest rates for 27 years and warned over the longest recession since the financial crisis.
The benchmark bank rate has been increased by half a percentage point to 1.75% from 1.25%. It is the biggest rate rise since 1995. Eight members supported the hike, while Silvana Tenreyro preferred the BoE to extend its streak of smaller 25 basis point rate rises instead.
However, the BoE flagged accelerating inflation is coming at the expense of economic growth, and the central bank expects the UK to enter into recession later this year.
It has lifted its consumer price inflation outlook to "just over 13%" in the fourth quarter of 2022, compared to its 9.4% forecast in its May report.
Inflation will "remain at very elevated levels throughout much of 2023, before falling to the 2% target two years ahead".
According to its projections, CPI will only return to the 2% target in the third quarter of 2024.
While inflation is accelerating, economic growth is slowing and gross domestic product will decline. It projects the UK to enter recession "from the fourth quarter of this year".
Turning to its economic projections, the BoE expects a 3.5% rise in GDP in 2022, lowered from an expected 3.8% rise in its May forecast.
The BoE also forecast that rocketing energy prices will push the economy into a five-quarter recession - GDP shrinking in the fourth quarter of this year and in each quarter throughout 2023.
Bailey also said the BoE took "forceful policy action" now to help avoid bigger hikes further down the line.
The pound was quoted at USD1.2075 late Friday, down from USD1.2115 at the close Thursday and is down 0.8% this week.
Rabo Bank's Jane Foley believes there is a risk that cable may trade as low as USD1.14 on a 1-to-3 month view following the BoE's dire warnings.
"The Bank of England's forecast of recession underpins the vulnerability of the pound going forward. The warnings on growth over-rode any support for the currency that may otherwise have been derived from the Bank's 50 bps rate hike, the largest incremental move in 27 years. The UK is facing months of astoundingly high inflation levels faced by a period of disinflation during potentially 5 quarters of negative GDP growth," said Foley.
Turning to the political front, Foley highlighted that UK Foreign Secretary Liz Truss is the favourite to win the Conservative party leadership race, as she continues her charm offensive aimed at Tory party members who will choose the next UK PM in September.
However, Foley noted that the foreign secretary's policies are not necessarily in line with investors' needs.
On Thursday, leadership rival Rishi Sunak warned that Truss's economic strategy will damage the nation, saying that pouring "fuel on the fire" will cause "misery for millions", after she insisted her tax cuts could avert the recession forecast by the BoE.
Truss used a televised debate on Thursday to warn of "very, very difficult times" without "bold" action rather than her Tory leadership rival's caution.
But Sunak, a former chancellor, struck back with fears her vision "will make the situation worse", on the day the Bank warned inflation could peak at 13.3% in October.
Interest rates were raised to the highest level in nearly three decades, from 1.25% to 1.75%, worsening the pain for mortgage holders, before the Bank predicted the economy will plunge into the longest recession since the financial crisis in 2008.
Sunak told the Sky News debate: "We in the Conservative Party need to get real and fast – because the lights on the economy are flashing red and the root cause is inflation.
"I'm worried that Liz Truss's plans will make the situation worse."
He stressed a need to get a grip on runaway inflation before cutting taxes, adding: "But it all starts with not making the situation worse.
Sunak said: "So what I'm not going to do is embark on a borrowing spree worth tens of billions of pounds, put that on the country's credit card, ask our kids and our grandkids to pick up the tab because that's not right. That's not responsible."
The financial focus of the battle to succeed Boris Johnson as prime minister only intensified with the Bank's warnings, with the contenders differing strategies already prominent as they try to win the Tory members who will select the winner.
Truss reiterated her pledge to immediately reverse the national insurance increase, introduced by Sunak when he was in No 11, as well as cut other taxes to prevent the job losses of a recession.
Sunak is fighting to make up ground on Truss, after polls put her around 32 percentage points ahead among Tory members.
Foley commented that both leadership hopefuls worked intimately with Johnson and as such, scope for a fresh start for the Tory party could be limited.
"Since Tory party members do not represent a broad representation of the UK electorate, the new PM could struggle to win broad based support in a country that will soon be diving into recession. Shortages of labour in the UK combined with the cost of living crisis are a recipe for strike action and possibly social unrest. This could lead to a choppy period for politics ahead of the 2024 general election. This would be another headwind for the pound," said Foley.
"GBP investors will be looking for clear leadership defined by prudence on fiscal matters and by policies designed to improve productivity and long-term growth potential. However, it is far from guaranteed that the next PM will have any more success in driving the country forward than Johnson," Foley added.
By Arvind Bhunjun; arvindbhunjun@alliancenews.com
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