Expectations for the Bank of England's interest rate rise

Increasing expectations in the markets for the Bank of England (BoE) Bank Rate are frequently cited as the main factor behind the rise in the value of the pound sterling, but they also run the risk of causing financial instability.

Sterling experienced a significant decline in midweek trading, but it still outperformed all other counterparts in the G10 basket and much of the G20 group for the year. The cause of this outperformance is the UK economy's unsettling inflation developments and the interest rate market's reaction to them.

Governor Andrew Bailey remarked at a news conference on Wednesday, "A lot of pundits have mentioned this, you know, that there are two aspects to it and you can see that, but I'll reiterate what I said at the Mansion House, and not for the first time, on Monday.

Even though core inflation, a more accurate measure of inflation in the UK, has actually increased since March, the increases in measures of wage growth and unemployment announced this week are even more concerning for financial stability and the outlook for the economy.

According to data released on Tuesday by the ONS, the unemployment rate increased to 4% in the three months leading up to the end of May, and both of the key measures of wage growth increased as well. As a result, interest rate swap markets started to suggest that the Bank Rate will likely be increased from 5% to 6.5% by the beginning of the following year.

This was an ongoing pattern that began at the end of March, but the most recent increases have brought implied rates above the peak of 6% that the BoE had assumed in the stress test it conducted as part of its most recent financial stability review, the findings of which were released on Tuesday and briefed on Wednesday.

The study by the BoE implies that the financial system should be able to withstand a Bank Rate of up to 6% because of the changes brought about by the crisis, but it also makes plain how a continuation of the increase in unemployment indicated on Tuesday might possibly put a wrench in those plans.

Although employment levels are regarded as a "lagging indicator" of economic health, they have historically been reluctant to adjust to recent changes in monetary policy. Currently, unemployment is growing and may climb much faster in the months to come.

The labour market is a liability for the economy and financial stability because unemployment causes loan defaults that jeopardise assets and capital reserves in the banking sector.

But if that were to happen, it would have an effect on more than just the economy and the resilience of the financial system because the rise in market expectations for the Bank Rate has been widely credited as being the main force behind the Pound's rally, which has gained momentum in recent months and made Sterling the best-performing major currency of the year.

(Sources: investing.com, poundsterlinglive.com)