- Policy divergence between the BoE and the Fed is dragging GBPUSD lower.
- A weaker pound is a pro-inflationary factor for the UK.
The US dollar posted its best daily performance since early March, thanks to an aggressive surprise from the Federal Reserve. Nine FOMC members indicated in their forecasts that one or more federal funds rate hikes would occur in 2026. Only one official predicted a cut, down from 12 in March.
Combined with Kevin Warsh's determination to return inflation to target at all costs and the removal of the statement of intent from the accompanying document, this led to a two and a half month high.
Kevin Warsh has managed to unite the FOMC. While there were four dissenting voices at the previous meeting, there were none at the June meeting. The accompanying statement was reduced from 345 to 132 words and the new president avoided statements of intent. In doing so, he is putting into practice his view that the Federal Reserve should look less to the past and focus more on the markets.
The Federal Reserve's hawkish rhetoric has raised the odds of a September rate hike from 29% to 62%. The probability of one rate hike in 2026 is estimated at 85%, and of two rate hikes at 46%. Combined with a rally in , this has strengthened the US dollar against major global currencies. Among other things, this has caused its steepest drop since February.
The Federal Reserve's willingness to tighten monetary policy complicates matters for the Bank of England. The forward market is not ruling out a 25 basis point rate hike in 2026. However, a growing number of investors are coming to the conclusion that borrowing costs will remain unchanged. The UK economy is showing signs of weakness and inflation, Bloomberg estimates, will peak at 3% in 2026. This is below the Bank of England's most optimistic scenario of a 3.6% price rise. The pessimistic scenario assumed that inflation would rise to 6% in early 2027.
If the Federal Reserve raises rates this year while the Bank of England leaves them unchanged, the divergence in monetary policy will drive down the GBPUSD exchange rate and accelerate UK inflation. In such circumstances, the best course of action for Andrew Bailey and his colleagues would be to adopt an aggressive tone. The door to a key rate hike should remain open, even if there is no need to act on it.
He FxPro Analyst team
