The EUR/GBP pair continues its losses for the second session in a row, trading around the 0.8710 level during European hours on Tuesday. Trading volumes are expected to be weak due to the end-of-year holidays. Traders are also monitoring geopolitical tensions as uncertainty over the peace process between Ukraine and Russia resurfaces. The Russian Foreign Minister said that Moscow’s negotiating position will change after the alleged attacks on President Vladimir Putin’s residence.
The EUR/GBP pair faces challenges as the British Pound (GBP) remains firm amid a dovish tone surrounding the Bank of England (BoE) policy outlook. While UK inflation slowed to 3.2% in November, it remains well above the Bank of England’s 2% target. UK GDP expanded 0.1% in the third quarter, matching expectations, but the Bank of England expects flat growth in the final quarter.
Bank of England Governor Andrew Bailey indicated that interest rates are expected to fall further in a gradual manner, but warned that the scope for further cuts is limited as interest rates approach their neutral level. Any moves beyond the recent cut are likely to be well balanced and strongly driven by incoming data. The Bank of England cut interest rates by 25 basis points to 3.75% in December, with a close 5-4 vote highlighting persistent concerns about inflation.
However, the downside for EUR/GBP could be limited as the Euro could receive support due to cautious sentiment surrounding the ECB policy outlook. The European Central Bank held interest rates steady in December and signaled they were likely to remain unchanged for some time, with its President Christine Lagarde noting that rising uncertainty makes forward guidance on future interest rate movements difficult.
Frequently asked questions for central banks
Central banks have the main task of ensuring that prices in a country or region are stable. Economies constantly experience inflation or deflation when the prices of certain goods and services fluctuate. A continuous rise in prices for the same goods means inflation, and a continuous fall in prices for the same goods means deflation. It is the responsibility of the central bank to maintain demand by adjusting the interest rate. For the largest central banks such as the US Federal Reserve (Fed), the European Central Bank (ECB), or the Bank of England (BoE), the mandate is to keep inflation near 2%.
The central bank has one important tool at its disposal to raise or lower inflation, and that is by adjusting its benchmark interest rate, known as the cash rate. At the moments announced in advance, the central bank will issue a statement on its interest rate and provide additional reasons as to why it will remain or change (lower or raise). Local banks will adjust their savings and lending rates accordingly, which will make it harder or easier for people to earn their savings or for companies to get loans and make investments in their businesses. When a central bank raises interest rates significantly, this is called monetary tightening. When the benchmark interest rate is lowered, it is called monetary easing.
The central bank is often politically independent. Members of the central bank’s policy board go through a series of committees and hearings before being appointed to a policy board seat. Each member of this board often has a certain conviction about how the central bank should control inflation and subsequent monetary policy. Members who want very loose monetary policy, with low interest rates and cheap lending, to boost the economy significantly while being content to see inflation just above 2%, are called “doves.” Members who want to see higher interest rates to reward savings and want to keep inflation down at all times are called “hawks” and will not rest until inflation reaches 2% or just below.
Typically, there is a chair or chair who presides over each meeting, needs to create consensus among the hawks or doves, and has the final say when it comes to dividing the votes to avoid a 50-50 tie on whether the current policy should be amended. The Chairman will often make live follow-up speeches, communicating the current cash position and outlook. The central bank will try to push its monetary policy forward without causing violent fluctuations in interest rates, stocks, or its currency. All central bank members will direct their stance towards the markets before the policy meeting. A few days before the policy meeting and until the new policy is announced, members are prohibited from speaking publicly. This is called a blackout period.
