What does the flash crash mean for UK interest rates?

Jake Cordell
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Governor Mark Carney Presents Bank of England's Financial Stability Report
The falling sterling could give Mark Carney a headache (Source: Getty)

The flash crash in sterling has sent UK inflation expectations to a three-year high and caused bond yields to spike.

Sterling sunk six per cent in a matter of minutes overnight before recovering some, but not all, of its losses.

In fact, the pound is still down more than two per cent against the dollar and the euro in a sign markets have been roundly spooked by the night's events and aren't completely buying it was just a freak occurrence.

The economic consensus is that a weaker pound will drive up the prices of imports and therefore lead to a jump in inflation, as the Office for National Statistics (ONS) pointed out this morning.

Expectations about how fast prices will rise - one of the crucial determinants for those setting monetary policy - have spiked to their highest level since the end of 2013, according to Reuters data. The markets are now pricing in inflation of 3.6 per cent on the five-year break-even inflation forward rate. The Bank of England's mandate is to target a medium-term inflation rate of two per cent.

Bond yields have also climbed dramatically in response to the pound's fall, with borrowing costs on the UK's benchmark 10-year bond climbing nine basis points to 0.97 per cent. The fall in the value of the pound this week has the same impact as a one percentage point interest rate cut, economist Shaun Richards points out.

Typically, higher inflation and rising bond yields could be seen as expectations of tighter monetary policy from the central bank in order to help it achieve its price stability target.

Howard Archer of IHS Markit said the flash crash "makes any further interest rate cut by the Bank of England at least this year look more unlikely".

Read more: Why did sterling suffer a flash crash?

He added: "Of course, if sterling falls sharply further and quickly, the Bank would even have to contemplate raising interest rates to provide some support - but I do not think we are anywhere near that point."

Societe Generale also said it believes the weak sterling "would make another quick rate cut risky" and should force the Bank of England to wait until at least next year to take interest rates any lower.

However, the Old Lady is unlikely to be roused into action as a result of the recent drop, Berenberg's Kallum Pickering told City A.M.

"Temporarily higher inflation, driven by sterling weakness, will not be a considerable part of the monetary policy committee (MPC)'s considerations," he said.

"It doesn't make sense for a central bank to raise interest rates when inflation dynamics are being driven by largely transitory and idiosyncratic factors. Central banks are only really concerned with domestically generated inflation - the stuff that comes from faster-than-expected wage growth or excess demand compared to supply."

He added: "Weak sterling really hurts UK households. Why would a central bank ... raise interest rates? It would be a mistake."

Read more: Is the Bank right to prioritise growth over price stability?

While rising bond yields can be seen as market expectations of tighter monetary policy, they also respond independently to inflation factors and global economic forces. Yields on US bonds have risen by 20 basis points over the past week, while 10-year borrowing costs for the German government also turned positive for the first time in two weeks.

Over the summer, the Bank of England indicated it would cut interest rates to "close to, but above" zero later this year in response to the fallout from the EU referendum. Even following a stream of good data, Mark Carney's ally Minouche Shafik said she still believed an interest rate cut would be needed.

What is going on with sterling?

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