Scott Bowman, UK Economist at Capital Economics, on UK economy and GBP

Source: Dukascopy Bank SA
© Scott Bowman
Having entered the EU referendum debate, the Bank of England governor Mark Carney underlined the benefits that the membership of the EU brings the UK. Carney stated that membership makes the UK more dynamic, giving it greater potential for growth, and more resilient to shocks. If the UK decides to leave the EU, this will have implications for how the BoE controls inflation and manages financial stability. However, if the free movement of labour was restricted, this may have an impact on supply and drive up inflation. What is your view on the matter? 

While we agree that membership of the EU has boosted the UK economy, we doubt that the outlook depends on the result of EU referendum. As such, we think the UK can do well either within or outside the EU. Even though certain low-wage sectors dependent on migrant labour, such as agriculture, may suffer from a restriction of free movement, we believe an exit from the EU could result in a better-designed migration policy. 

The Brexit could allow a more sensible migration policy based on skills, rather than nationality, improving the effective pool of labour. What is more, being freed from the EU regulations could allow a more flexible labour market. Meanwhile, even if the Brexit was to cut migration and the supply of labour, demand for goods and services would probably also fall, containing any rise in inflation. 

Analysts believe that the BoE will hike interest rates from 0.5% to 0.75% sometime in the first half of 2016 and will later on proceed with another rate hike in Q4, leaving rates at 1% by the end of 2016. Do you in fact consider them to be right? What is your outlook on the issue? 

We expect the first rate hike to occur in Q2 2016 and a second hike in Q4. Other analysts have come round to our view, with the consensus expectation of other economists for the first rise shifting from Q1 to Q2 over recent weeks. Meanwhile, we think there will only be very gradual increases thereafter, as inflation takes a long time to get back to target as previous falls in energy prices make their way through the economy and as productivity stages a rebound, keeping unit wage costs down. That said, market participants expect an even more gradual increase in interest rates, with rates only expected to reach 1% by the end of 2017. 

What will be the major headwinds for the Pound and what are your forecasts for EUR/GBP and GBP/USD until the end of 2015 and for the longer term prospective? 

We think that currency movements will be determined by interest rate differentials relative to market expectations. As such, our view that the Fed will need to tighten monetary policy faster than market participants anticipate, as disappointing productivity fails to contain unit labour costs and inflation, means we expect the USD strength in coming quarters. However, the Sterling could rise in coming quarters against the Euro, given that we expect that the ECB will ease policy further by the end of the year. Accordingly, we see the GBP/USD falling to 1.50 by the end of 2015 and 1.40 by the end of 2016. The EUR/GBP is expected to reach 0.73 at the end of 2015 and 0.71 by the end of 2016.

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