Against the backdrop of diverging global monetary policies and persistent energy-driven inflation, the Bank of England's policy choices are sinking into an increasingly complicated situation.
Lloyds Bank has issued a fresh warning that points directly at the core contradiction: the UK following the Federal Reserve in raising rates may no longer be able to support the pound, and policymakers are now facing a costly game with little payoff.
The support effect of rate hikes is weakening, and sterling's trajectory is diverging
Lloyds Bank made clear that higher UK interest rates can no longer deliver the effective boost to sterling that they once did. Karim Henide, the bank's rates strategist, said that if the UK simply follows the Fed chair's policy path, it will only bear the economic cost of tighter policy without gaining any relief at the exchange-rate level.
In Tuesday's (October 13) Asian session, sterling edged higher against the dollar and was last trading near 1.3215, close to a three-month low, with a gain of about 0.2%. Against the euro, sterling held at 1.1835, near its high for the year.
Lloyds Bank still believes it is highly likely that the Bank of England will raise rates in November.
The exchange-rate transmission mechanism has shifted, and policy effectiveness is fading
Henide further noted that in the past, UK monetary tightening could effectively lift sterling, but that effect has weakened substantially in recent years. A weaker exchange rate will continue to push up the prices of imported goods at home, in turn forcing inflation higher.
Using data comparisons, he explained that between 2017 and 2019, the Bank of England needed only a 10-basis-point rate hike to drive sterling up by about 1.5% against the dollar; however, since 2022, the same-sized hike has had almost no material impact on the exchange rate.
He argued that a 1% depreciation of sterling would push UK inflation up by about 7 basis points over two years, and further exchange-rate weakness would make standing pat difficult to sustain. Yet the UK benchmark rate's influence on the exchange rate is no longer what it was, and a rate hike would not only weigh on households and businesses through higher borrowing costs, but also fail to deliver the dividend of lower import costs as it did in the past.
Market expectations are mismatched with policy
Henide said the bond market appears to be ignoring the fact that the UK faces a harder trade-off between economic growth and inflation. According to model estimates, under a strict inflation target and mainstream economic forecasts, the optimal average Bank of England rate in 2027 would be about 4.2%; if the Monetary Policy Committee chose to ignore the first-round energy shock, that level would be about 3.5%, significantly below the 4.59% currently priced by the market.
It should be clarified that these results are conditional estimates of annual averages, not final year-end rate forecasts. The logic supporting this market pricing assumes that Brent crude would need to average around $125 per barrel throughout 2027.
Henide explicitly stressed that one key reason rate hikes have become inappropriate is the lag in policy. The tightening effect of rate hikes often only fully materializes after inflation has already fallen significantly, which would greatly increase the risk that forward inflation undershoots the target. In scenario simulations, the current pricing path is expected to reduce inflation by about 0.3 percentage points by the fourth quarter of 2028, at the cost of a 0.38 percentage-point rise in the unemployment rate.
Lloyds Bank also found a deeper contradiction, namely a clear misalignment between market expectations for rates and for inflation. Market inflation contract pricing shows that even after the expected rate hikes, price pressures will remain more stubborn than model forecasts suggest. Henide admitted that market pricing sends a signal that tightening policy is ineffective, and given that the current demand-side toolkit struggles to address supply-driven inflation pressures, he agrees with that view.
Energy inflation worries persist, and the Bank of England's policy room is constrained
If expensive energy costs continue to pass through into wages and other goods prices, the Bank of England's room to stand pat will be greatly constrained. Henide pointed out that how much policy flexibility the Monetary Policy Committee can retain depends largely on the pass-through effect of energy prices. History shows that the UK tends to have stronger second-round inflation pass-through than the United States, which provides a natural reason why it cannot simply ignore the first-round energy shock.
It is worth noting that in its September meeting, the Bank of England decided to keep the benchmark rate at 3.75%, and its statement also mentioned that there is currently no sign that second-round inflation effects have become significantly evident, but if energy prices remain elevated for a long time, the related risks will be amplified. The next rate decision is expected to be announced on November 5.
Conclusion
In summary, sterling's trajectory will become a key variable determining the Bank of England's policy flexibility. A firm exchange rate can provide the central bank with a buffer against external tightening pressure, while a weak exchange rate will force the central bank toward a more hawkish stance, even if such rate hikes can no longer support sterling as they did before 2022. With the global macro environment complex and fast-changing, the market is closely watching how the Bank of England will seek a difficult balance between controlling inflation and stabilizing the exchange rate.
GBP/USD daily chart Source: E-Huitong. At 12:26 Beijing time on October 13, GBP/USD was quoted at 1.3217/18.