How will central bank policy impact GBP/EUR in the months ahead?

Central banks around the world have been aggressively raising interest rates over the past year, bringing borrowing costs to levels not seen since the 2008 financial crisis, in order to tame runaway inflation.

Now that inflation seems to have passed its peak, many of these banks have indicated that they will stop tightening monetary policy.

However, the Bank of England (BoE) and the European Central Bank (ECB) have both indicated that they have more work to do. Inflation has proved more persistent than expected time and again, with second-round inflation effects worrying central bank policymakers.

So, what is the potential for more rate hikes from the BoE and the ECB, and how could this impact the GBP/EUR exchange rate?

The Bank of England

At the start of 2023, analysts were expecting the BoE to soon pause its rate-hiking cycle in the face of a looming UK recession and easing inflationary pressures.

However, the British economy has been far more resilient than feared, and inflation proved more persistent. The BoE expected inflation to fall sharply from April, and although headline inflation did cool from 10.1% to 8.7%, core inflation spiked from 6.2% to 6.8% – a 31-year high.

The latest data suggests that the BoE may need to continue hiking rates. Towards the end of May, markets were expecting UK Bank Rate to peak at 5.5%, up from 4.5%.

Yet some economists believe these forecasts are overblown. It takes around 18 months for monetary policy to feed through into the economy, so the impact of the bank’s most recent rate hike may not be fully felt until winter 2024.

If the BoE does raise rates to 5.5%, we could see Sterling strengthen through the second half of 2023. But if rapidly cooling inflation prompts a pause in the bank’s policy tightening after June, the pound could struggle to climb higher.

Once the bank is done hiking, the focus shifts to rate cuts. If the UK economy continues to show resilience, the BoE may hold rates higher for longer, keeping GBP afloat.

The European Central Bank

The Eurozone, on the other hand, has seen inflation fall more steadily. The bloc’s inflation rate dropped from a peak of 10.6% in October 2022 down to 7% by April 2023. Core inflation is stickier, however, hitting a record high of 5.7% in March and only easing slightly to 5.6% in April.

Meanwhile, many are growing concerned about the health of the Eurozone economy. Recent data has missed forecasts, indicating a slowdown. In fact Germany – the largest economy in the Eurozone – suffered a technical recession in the winter after GDP contracted 0.5% in Q4 2022 and 0.3% in Q1 2023.

At its May meeting, the ECB reined in its forward guidance for more rate hikes, causing the euro to fall. ECB policymakers have since advocated for further tightening, with the bank’s President Christine Lagarde saying policymakers would ‘be courageous’ to tame inflation.

The mixed messaging suggests that the ECB may be close to ending its hiking cycle, but it doesn’t want to undo some of its work by sounding too dovish.

Markets are pricing in another 25bps hike in June, which would bring the ECB’s main deposit rate to 3.5%. After that, more rate rises are possible if the data supports them.

If the Eurozone economy continues to stutter and inflation cools, then the ECB may not raise rates as high as markets anticipate. Ongoing weakness in the bloc may also prompt the bank to start cutting rates earlier than expected, which would likely see the euro stumble.

Ongoing GBP/EUR volatility

Whatever the European and British central banks decide to do, one thing remains certain – there is significant potential for ongoing volatility in the currency markets.

Inflation and interest rates have repeatedly overshot market expectations, while central banks are abandoning forward guidance in favour of a wait-and-see approach. This creates uncertainty, which often leads to more unpredictable exchange rate movements as markets find it harder to predict and price-in policy decisions.

This could lead to more big swings in GBP/EUR, which can cause headaches if you need to move money overseas. A seemingly small change in the exchange rate can lead to significant discrepancies when trading larger amounts.

Fortunately, you can minimise this risk and maximise opportunities by using a specialist currency broker, such as Currencies Direct. We offer expert insights and specialist services to help you navigate the ups and downs of the currency market.