GBP/USD exchange rate dented by central bank policy decisions in December
An upwardly revised UK PMI, lacklustre US jobs data and expectations that the Bank of England (BoE) may be slower to cut interest rates than other central banks lifted the pound to within a whisker of the $1.28 benchmark on 6 December.
The pound dollar exchange rate traversed the $1.27 range until 11 December, when the US consumer price index showed inflation picked up to a four-month high in November. This prompted investors to reduce expectations for Federal Reserve rate cuts in early 2025. By the end of the following day, the pair had slumped to around $1.262 after the producer price index for November, which exceeded expectations, confirmed persistent inflationary pressures in the US.
The dollar rose sharply on 18 December following the Fed’s latest interest rate decision, which overshadowed an uptick in UK inflation amid concerns over how price pressures could hinder the UK economy. With the US central bank’s 25 basis-point rate cut widely priced in, the Fed’s hawkish tone bolstered dollar sentiment, causing the pound to fall into the $1.25 mid-range.
The UK currency extended its losses the following day, falling below $1.25, despite the BoE’s decision to leave its monetary policy unchanged, as expected. However, three of the central bank’s nine policymakers voted to cut rates to stimulate the economy after the BoE lowered its growth forecast – a dovish tilt that soured pound sentiment.
The pound rebounded more than 1% on 20 December to within touching distance of the $1.26 benchmark due to downward pressure on the dollar.
With data thin on the ground, the pound dollar exchange rate traded sideways through the $1.25 range during the Christmas period, ending the year at around $1.251.
2025 outlook
Pound
UK inflation data and its impact on the pace of BoE interest cuts will be in sharp focus for investors in the pound in 2025. Despite a dovish tilt to the central bank’s interest rate hold in December amid growth concerns, apprehension about rising headline inflation and services price inflation will persist – potentially supporting the pound if it forces the BoE to keep rates higher for longer.
Since dropping below the BoE’s 2% target in September headline inflation has been heating up again. According to the Office for Budget Responsibility (OBR), the consumer price index is likely to average out at 2.6% in 2025, partly due to huge budgetary tax rises and spending hikes. Similarly, services inflation, a closely watched gauge of underlying domestic price pressures, is stuck at 5% and is expected to remain around there well into the year.
Despite inflationary pressures, the BoE is expected to lower interest rates gradually in 2025. However, investors have scaled back their expectations amid economic uncertainty to two quarter-point rate cuts from four as recently as October, with the next cut anticipated in May – a hawkish readjustment that is likely to support the pound if it plays out.
The UK currency’s gains could be limited if faltering growth caused by hotter inflation and higher interest rates increases pressure on the BoE to unwind policy to revitalise the economy.
Euro
With the battle to tame inflation in the Eurozone almost won, the ECB has been cutting interest rates at a brisk clip. But is it unwinding monetary policy fast enough to support a flagging economy that’s at risk of sliding into recession? The euro’s fortunes will be heavily influenced by economic growth in the bloc in 2025 amid headwinds from Donald Trump’s proposed trade tariffs and economic instability in Germany and France, the region’s two largest economies.
According to analysts, an urgent need to ensure long-term economic stability in the Eurozone will result in the ECB maintaining its current 25bps rate cut pace until September – a dovish outlook that could dent the euro. There could be scope for the central bank to accelerate to 50bps if economic conditions permit, heaping more pressure on the euro.
This will be dictated by key economic figures, not least GDP data from France, Germany and the wider region. If growth disappoints, pressure will increase on the ECB to prop up the economy by making its policy less restrictive.
Inflation shouldn’t present a barrier to the ECB reducing interest rates as confidence it will cool to the central bank’s 2% target rises. They must find the right balance, however, as looser policy risks stoking inflation, a scenario that could deter the ECB from cutting rates and subsequently support the euro.
Dollar
Following their sweep of both houses of Congress, Donald Trump and the Republican party will be equipped with the power to implement looser fiscal policy, tighter immigration and widespread trade tariffs – a potential recipe for dollar strength. Trump’s inauguration on 20 January could bolster the dollar after the President-elect said one of his first tasks will be to sign off a 25% trade tariff on Mexico and Canada.
While Trump’s proposed policies have led investors to raise bets on the Fed keeping rates higher for longer, borrowing costs are expected to fall in 2025 – the question is how much and how fast? Fed rate-setters will closely monitor US inflation figures as they search for answers.
According to a recent Bloomberg survey of economists, the annual core personal consumption expenditures price index – the Fed’s preferred gauge of inflation – will advance 2.5% on average this year, up from a previous projection of 2.3%. If this forecast proves accurate, the Fed will be expected to leave rates unchanged – a move that’s likely to support the dollar.
The Fed lowered rates for a third straight meeting in December but is now pencilling in just two quarter-point cuts this year amid sticky inflation – with the first reduction expected in June. This divergence from the ECB’s quicker pace of policy easing could fuel dollar strength against the euro.
The dollar’s gains could be limited, however, if the Trump trade – the positive market sentiment to his proposed policies – that has injected strength into the US currency since the election dissipates after his inauguration as his proposals become a reality.