Who Will Raise Interest Rates First…The US Or UK?

Given the recent performance of GBP/USD the forex markets seem to be veering towards the US raising interest rates first, but there's still a chance that the Bank of England could pip the US Federal Reserve to the post. 

If the UK does go first, or is seen to do so, it would suggest that GBP has been oversold versus the USD and there are reasons to believe it still could.

This month the US Federal Reserve is set to end quantitative easing in a sign that the US economy and financial system have recovered. The Bank of England made its last purchase under its QE programme in July 2012. Since then the UK economy has steadily recovered.

The IMF forecasts that UK GDP will have grown by 3.2% this year and will do 2.7% next year making it the fastest growing economy among the G7 in 2014. It sees US GDP expanding at 2.2% this year and 3.1% next year. The US unemployment rate is 5.9% and the UK's is 6.1%

Despite strong UK numbers GBP/USD is still heading down.

A finely balanced argument

The argument over which country will go first is a finely balanced one and in the first half of this year it was widely expected the UK would take the lead. But with the US on course to wind down QE and a recent good run of GDP and jobs data have shifted expectations towards the US being the first off the starting blocks.

However, there are still some reasons to believe the UK could still go first. It has already stopped QE and now has fast rising house prices. Property booms have always been ominous for the UK often ending in busts, which harm the economy. Historically, the UK has been more inflation prone than the US – though rising prices remain subdued in both economies for the time being.

Following the financial crisis, the Bank of England will be particularly vigilant over the formation of a housing bubble. Indeed, the IMF warned that UK interest rates may have to rise more quickly than expected if house prices and inflation get carried away.

The BoE could copy Eire's central bank, which is introducing lending curbs for property buyers in a bid to slow the pace of property price increases there. However, a rate rise in the UK, which is enjoying a strong economic recovery, would be a way for the BoE to signal that monetary policy is now normalising. It's a message the Fed is also keen to impart.  

Whoever goes first, the message on both sides of the Atlantic is that rate rises will be modest and gradual. Actually, the sooner they start the more likely that monetary policy can be changed more slowly. Leave it too long and the central banks may once again have to play catch up as they did during the early stages of the financial crisis – the risks of negative side effects from delaying rate rises appear more pronounced in the UK than the US at the moment.

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