- Monetary stability - aiming for stable prices and low inflation.
- Financial stability - safeguarding the soundness and prosperity of the economy.
Monetary Stability:
Keeping monetary stability is vital for the overall economy. It seeks to avoid high inflation and keep inflation expectations steady, enabling the economy to grow smoothly. To attain stable prices, the Bank of England and its monetary policy committee (MPC) have established a 2% inflation target.
If inflation goes beyond the 2% target, the Bank of England may opt to raise interest rates. This action could result in an appreciation of the Pound as investors shift capital flows towards the currency offering higher returns. However, there could also be adverse effects on the stock market, as businesses face higher lending costs and equity valuations are reduced at higher interest rates. Tracking monetary policy data can be done through the economic calendar.
Nonetheless, the Bank of England may not always increase interest rates when inflation surpasses the target. In some situations, such as when GDP growth is low or negative, the Bank may keep interest rates low to boost the economy. Finding a balance between healthy inflation and economic growth is crucial for the Bank of England.
Financial Stability:
The soundness of the financial system is essential for the well-being of the UK economy, making it a major concern for the Bank of England. To support financial stability objectives, the bank has a Financial Policy Committee (FPC), established in June 2011. From a foreign exchange (FX) perspective, monetary stability remains the main determinant of spot rates for the GBP.
THE EFFECT OF BOE INTEREST RATES ON THE POUND
How interest rate changes influence the Pound
The value of the Pound is influenced by the expectations of interest rate changes by the Bank of England. Traders need to know that currencies appreciate when the market anticipates higher interest rates, not just when the actual interest rate goes up.
For example, if the Bank of England keeps the interest rate steady but signals to the market that they plan to raise it more in the future, the value of the Pound will go up. On the other hand, if the market expects fewer interest rate hikes or even a cut in the future, the value of the Pound will go down.
This is the general rule for how interest rates affect the Pound and stock market, although they may react differently sometimes:
Higher interest rate expectations strengthen the Pound (GBP) and lower equity values. Lower interest rate expectations weaken the Pound (GBP) and raise equity values. Interest rates are not the only monetary policy tool that can affect the currency, tools like quantitative easing can also have an impact on the currency value. If the Bank of England announces that it will start a quantitative easing program (QE), the pound will likely lose value as a lot of liquidity enters the market, increasing the money supply and leading to a decrease in interest rates, or, simply to maintain current rates.
How interest rate changes affect the economy
The Bank of England lowers interest rates when it wants to boost the economy (GDP) and raises interest rates when it wants to control inflation caused by an economy operating above its potential (overheating).
Lower interest rates boost an economy in a few ways:
Businesses can borrow money and invest in projects that will earn more than the cost of borrowing. When interest rates are lower, the stock market is discounted at a lower rate, leading to an increase in stock market values which causes a wealth effect. People invest their money into the economy (stocks and other assets) because they can earn more in these assets than at currently low interest rates. How to trade BOE interest rate decisions
The table below shows the possible scenarios that result from a change in interest rate expectations. Traders can use this information to predict if the currency is likely to appreciate or depreciate and how to trade it.
| MARKET EXPECTATIONS | ACTUAL RESULTS | RESULTING FX IMPACT |
|---|---|---|
| Rate Hike | Rate Hold | Depreciation of currency |
| Rate Cut | Rate Hold | Appreciation of currency |
| Rate Hold | Rate Hike | Appreciation of currency |
| Rate Hold | Rate Cut | Depreciation of currency |
- The value of the Pound depends on the Bank of England
- The Pound will go up or down based on the expectations of interest rate changes, not just on the actual changes.
- Quantitative easing has a similar impact to interest rate changes.
- Expectations of quantitative easing will also affect the Pound.
- Higher inflation does not mean the Bank of England will raise interest rates, it depends on the trade-off between economic growth and inflation.