British Pound Outlook: Lloyds Warns Against Following Fed Rate Rises

Pound Sterling Forecast: Lloyds Warns Rate Rises May Offer Little Support

Higher UK interest rates could leave the Pound struggling for support, Lloyds warns, as following the Fed risks imposing greater costs on the economy.

Higher UK interest rates may no longer provide the lift to Sterling that investors once expected, according to Lloyds Bank, leaving policymakers facing a costly choice if the Pound weakens further.

Rates strategist Karim Henide writes: “Following the Fed may therefore impose the costs of tighter policy without currency relief.”

Pound Sterling‘s performance on Monday was mixed, with GBP/USD near $1.3206, down around 0.2%, while GBP/EUR traded near €1.1835, close to its high for the year.

Lloyds still regards a November Bank of England increase as likely.

The British Pound has become less responsive to UK rates

Lloyds estimates that currency weakness still feeds inflation, while UK tightening has become less effective at supporting Sterling.

Henide writes: “Additionally conditioning the MPC’s ability to retain optionality is sterling resilience. A 1% fall in GBPUSD adds c. 7bp to UK CPI over two years; further weakness could make inaction hard to sustain. However, the Bank Rate’s influence on sterling has weakened sharply. 10bp of UK tightening lifted GBPUSD by c. 1.5% in 2017-19, but has had little effect since 2022.”

A cheaper Pound raises the domestic cost of imports, including goods priced in Dollars.

The resulting inflation pressure could push the Monetary Policy Committee towards higher rates even if the currency response remains weak, leaving households and businesses facing more expensive borrowing without much relief from import costs.

MUFG sees a November rate rise supporting Sterling, while Lloyds’ concern centres on the limited currency benefit of following the Fed beyond that meeting.

A November increase need not start a prolonged series

Henide argues that bond markets are treating the British and American policy outlooks too similarly despite the UK’s less favourable trade-off between growth and inflation.

Henide writes: “The optimal 2027 average Bank Rate given consensus economic projections is c. 4.2% under a strict inflation target, and c. 3.5% for an MPC that looks through first-round energy effects (vs. 4.59% priced).”

Those are conditional model results for an annual average, rather than a year-end rate forecast.

To justify the pricing used in the report, Lloyds calculates that Brent would need to average about $125 throughout 2027, with policymakers fully responding to its direct inflation effects.

Henide writes: “A key reason behind the progressive suboptimality of hikes is the policy lag; the hikes would be expected to transmit after meaningful disinflation is expected to arrive, increasing the risk of undershooting target further out the curve. Under our scenario modelling, the priced path takes c. 0.3pp off CPI by 4Q28 (back-loaded), at the cost of a 0.38pp rise in unemployment.”

The inflation reduction arrives largely later in the model, by which time earlier energy-price increases are expected to be dropping out of annual comparisons.

Lloyds also identifies a mismatch between markets’ interest-rate and inflation expectations, with inflation contracts allowing for more persistent price pressures than its model produces even after the anticipated hikes.

Henide writes: “Pricing reflects an inflation path that looks as though the tightening is ineffective. We are sympathetic with this view, given the misalignment of the demand-focussed toolbox and the predominantly supply-focussed source of mandate pressures.”

Persistent energy inflation could restrict the Bank’s room to wait

The risk to that view is that expensive energy spreads into wages and other prices, making inflation harder to reverse.

Henide writes: “Therefore, how much optionality the MPC is reasonably able to retain depends on energy (second-round pass-through in particular). The UK has typically seen stronger second-round pass-through than the US, a natural argument against looking through first-round effects.”

He nevertheless finds that energy’s transmission into wider UK inflation has faded, potentially giving policymakers more scope to avoid responding mechanically to the initial price shock.

The BoE’s September decision to hold Bank Rate at 3.75% reflected a similar tension.

Its statement said: “There has been little evidence so far of material second-round effects in price and wage-setting.”

Policymakers nevertheless warned that the risk would grow if energy prices stayed elevated.

The next decision is due on 5 November.

Sterling’s behaviour will help determine how much flexibility the MPC retains, Henide concludes: “Sterling is likely to be a key determinant of MPC responsiveness; a resilient currency affords the MPC room to resist imported Fed tightening; further weakness forces a more hawkish response, even if higher rates no longer support the currency as they did before 2022.”

Near-Term GBP and Interest Rates FAQ

Does Lloyds expect a November BoE rate rise?

Yes, it considers an increase likely, but questions the case for following the Fed with prolonged tightening.

Why might higher interest rates fail to strengthen the Pound?

Lloyds finds that Sterling has become less responsive to UK tightening, leaving higher borrowing costs without the currency support seen in earlier years.

Is 3.5%-4.2% a firm Bank Rate forecast?

No. It describes conditional model estimates for the average rate during 2027, depending on how policymakers respond to energy-driven inflation.