Fundamental Forecast for British Pound: Neutral

- Technical Positioning Hints Pound to Reverse Lower vs US Dollar
- Rates Outlook Key as British Pound Clings to UK-US Libor Spread

The British Pound may turn volatile in the week ahead as the Bank of England delivers the first rate decision based on an updated inflation outlook taking into account the government’s austerity budget.

Relative near-term monetary policy considerations remain in focus, with GBPUSD tracking closely with the spread between UK and US one-month Libor rates. Naturally, this puts the onus on next week’s Bank of England interest rate decision. The outcome will be based on an updated quarterly inflation report, this time taking into account the government’s ambitious austerity budget that aims to trim the public deficit by a hefty 6.3 percent of GDP by 2014-15. To that effect, traders will be keen to size up the central bank’s take on the plan’s implications for economic growth and monetary policy going forward.

Government spending has been a key driver of the UK recovery, hinting that the significant retrenchment on the fiscal will call for monetary policy to (at least) remain at the current, accommodative setting for the time being to prevent a slide back into recession. Indeed, a convincing argument can be made for further easing despite stubbornly high CPI inflation as temporary upward pressures including a weaker sterling filter out of the equation. Still, BOE policymakers continued pushing a neutral tone in last week’s testimony to the Parliament’s Treasury Committee, with Governor Mervyn King downplaying the stronger-than-expected second quarter GDP result to stress lingering uncertainty about the recovery in general and inflation in particular.

On balance, the path of least resistance seems to point toward a static monetary policy for the time being. While the bank itself has argued that elevated inflation is a temporary development, there seems to be no immediate reason to be offering additional stimulus. That said, tightening is surely out of the question as austerity looms ahead. This points toward no changes in the key elements of monetary policy (interest rates, asset purchases), pointing the spotlight on policymakers’ verbiage for clues on their thought process about where to go from here.

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