The British pound rises to a two-and-a-half-year high against the U.S. dollar

On Tuesday, the GBP/USD exchange rate rose to its highest level since March 2022 as investors anticipated that the Federal Reserve would start cutting rates faster than the Bank of England.

The pound briefly increased by 0.4% to 1.3246 against the dollar before pulling back slightly, but the currency pair is still on track for its best monthly performance since November of last year.

Last week, top decision-makers at the Federal Reserve and the Bank of England expressed differing views on the outlook for interest rates.
At the Jackson Hole central bank symposium, Fed Chairman Powell stated that the "timing is right" for a rate cut in the U.S., while Bank of England Governor Bailey warned that it is "too early to declare victory over inflation."

Kyle Chapman, a forex analyst at Ballinger Group, noted that the sharp contrast between Powell’s green light for rate cuts and Bailey’s more cautious stance at Jackson Hole encapsulates the factors supporting the pound's strength.

In recent months, the pound has been bolstered by stronger-than-expected economic data and market optimism about the new government's potential for political stability and growth-promoting reforms.

In August, UK private sector activity grew faster than anticipated, reaching a four-month high. Derek Halpenny, Head of Research at MUFG, noted that second-quarter economic growth of 0.6% was also "well above" market expectations.

However, inflation in the UK’s service sector remains stubbornly above 5%. Geoff Yu, a forex strategist at BNY Mellon, indicated that the annual wage growth in the UK also reduces the urgency for the Bank of England to cut rates.

For the three months ending in June, UK wage growth slowed to a near two-year low of 5.4%, though the unexpected drop in unemployment suggests a still-strong labor market.

The uncertainty surrounding the UK economic outlook led to a split among Bank of England policymakers in early August over the rate cut, marking the first rate cut by the Bank in over four years. Traders are betting on a one percentage point cut by mid-next year.

In contrast, investors expect the Fed to cut rates seven to eight times by mid-next year, each by 25 basis points. Traders are currently divided on whether the Fed's first rate cut next month will be 25 or 50 basis points.

Last Friday, Bailey provided some encouraging news on UK inflation, suggesting that "second-round inflation effects seem to be smaller than expected."

According to trading platform Capital.com, the upcoming inflation data favored by the Fed may play a crucial role in determining whether the pound can maintain its gains.

Daniela Sabin Hathorn, an analyst at Capital.com, stated in a report that if the U.S. PCE data released on Friday reinforces expectations for a Fed rate cut at the September meeting, the pound could appreciate further. However, if the data is stronger than expected, the pound might reverse some of its recent gains.

Halpenny from MUFG commented:
“Bailey’s remarks indicate increasing optimism at the Bank of England and a reduction in concerns about persistent inflation... but after Powell’s speech, it sounds somewhat hawkish and suggests that future policies of the Bank of England and the Fed may diverge.”

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