Inflation is the rate of increase in the prices of goods and services over time. It affects the purchasing power of money and the cost of living. Inflation can also have an impact on the exchange rate of a currency, which is the price of one currency in terms of another.

UK inflation rate in 2023

According to the latest data from the Office for National Statistics (ONS), consumer price inflation (CPI) in the United Kingdom rose by 8.7% in the 12 months to May 2023, unchanged from April. This was above the market expectations of 8.4% and well above the Bank of England's target of 2%. The CPIH, which includes owner occupiers' housing costs, rose by 7.9% in the same period, up from 7.8% in April.

The main drivers of inflation in May were rising prices for air travel, recreational and cultural goods and services, and second-hand cars, which resulted in the largest upward contributions to the annual rate. On the other hand, falling prices for motor fuel and food and non-alcoholic beverages led to the largest downward contributions to the annual rate.

The core CPIH, which excludes energy, food, alcohol and tobacco, rose by 6.5% in the 12 months to May 2023, up from 6.2% in April, and the highest rate for over 30 years. The core CPI rose by 7.1% in the same period, up from 6.8% in April, and the highest rate since March 1992https://www.ons.gov.uk/economy/inflationandpriceindices.

The ONS attributed some of the inflationary pressures to temporary factors related to the coronavirus (COVID-19) pandemic, such as supply chain disruptions, higher transport costs, and base effects from low prices a year ago. However, some analysts have warned that inflation could persist for longer than expected due to strong consumer demand, labour shortages, and rising wages.

The Bank of England has forecasted that inflation will peak at around 10% by the end of 2023, before falling back to around 2% by mid-2024. The Bank has also signalled that it will start raising interest rates gradually from early 2024 to keep inflation under control.

UK inflation and currency market

Inflation can affect the exchange rate of a currency through various channels. One channel is through interest rates. Higher inflation can lead to higher interest rates, which can make a currency more attractive to investors who seek higher returns. This can increase the demand for the currency and push up its value relative to other currencies.

Another channel is through purchasing power parity (PPP). PPP is a theory that states that the exchange rate between two currencies should equalise their purchasing power. In other words, a basket of goods and services should cost the same in both countries when converted at the exchange rate. If one country has higher inflation than another, its currency should depreciate relative to the other country's currency to maintain PPP.

A third channel is through expectations. Inflation can affect the expectations of consumers, businesses, and investors about the future value of a currency. If inflation is expected to rise or persist, it can erode confidence in a currency and reduce its demand. This can lower its value relative to other currencies.

The effect of inflation on exchange rates depends on various factors, such as how inflation compares with other countries, how monetary policy responds to inflation, how inflation expectations are formed, and how other economic variables interact with inflation.

In general, higher inflation tends to weaken a currency's value relative to other currencies with lower inflation. However, this is not always the case. For example, if higher inflation is accompanied by stronger economic growth or productivity gains, it can boost a currency's value by increasing its attractiveness or competitiveness.

UK pound sterling in 2023

The UK pound sterling (GBP) is one of the major currencies in the world. It is influenced by various factors, such as economic performance, trade balance, fiscal policy, political stability, Brexit negotiations, and global market sentiment.

In 2023, GBP has faced some challenges due to high inflation and uncertainty over Brexit outcomes. GBP has depreciated against most of its major trading partners' currencies since January 2023.

According to Trading Economics, GBP has fallen by 5.6% against the US dollar (USD), by 4.9% against the euro (EUR), by 6.9% against the Japanese yen (JPY), and by 4.5% against the Swiss franc (CHF) as of June 2023.

The main reasons for GBP's weakness are:

• High inflation: The UK has experienced higher inflation than most of its peers, which has eroded GBP's purchasing power and reduced its attractiveness to investors. Although the Bank of England has signalled its intention to raise interest rates, the market has priced in a slower and smaller pace of tightening than expected, which has limited GBP's upside potential.

• Brexit uncertainty: The UK and the EU have been locked in negotiations over the implementation of the post-Brexit trade deal, which has been marred by disputes over issues such as the Northern Ireland protocol, fishing rights, and financial services. The lack of clarity and progress on these matters has increased the risk of trade frictions and legal challenges, which has weighed on GBP's sentiment.

• Global factors: GBP has also been affected by global factors, such as the strength of the USD, the recovery of the eurozone economy, the rise of COVID-19 variants, and the geopolitical tensions between the US and China. These factors have influenced the demand and supply of GBP in the international market, as well as the risk appetite and volatility of investors.

Conclusion

Inflation is a key economic indicator that can have significant implications for the exchange rate of a currency. In 2023, the UK has faced high inflation, which has put downward pressure on GBP against other major currencies. However, inflation is not the only factor that affects GBP's value. Other factors, such as economic growth, trade balance, fiscal policy, political stability, Brexit negotiations, and global market sentiment, also play a role in determining GBP's exchange rate.

Reduce the risk by using Forward contracts.

Nexdi is here to help customers who have regular international payments in various currencies. Based on the above high inflation and Interest rate hikes the risk is very high that the value of your foreign currency payments or receipts will change due to fluctuations in exchange rates. One way to manage this risk is to use forward contracts offered by Nexdi.

To book a forward contract, please speak to your account manager who will be happy to assist in placing the deals for you.