On February 7th, The Monetary Policy Committee (MPC) of the Bank of England (BoE) decided to leave interest rates at the rock bottom rate of 0.5%. In doing so, the MPC acknowledged that it was assuming that the current stubbornly high inflation would eventually return to the target 2%. The MPC is expecting productivity gains and the reduction in external price pressures to do the trick.
“Inflation has remained stubbornly above the 2% target. Despite subdued pay growth, weak productivity has meant no corresponding fall in domestic cost pressures. And increases in university tuition fees and domestic energy bills, largely resulting from administrative decisions rather than market forces, have added to inflation more recently. CPI inflation is likely to rise further in the near term and may remain above the 2% target for the next two years, in part reflecting a persistent inflationary impact both from administered and regulated prices and the recent decline in sterling. But inflation is expected to fall back to around the target thereafter, as a gradual revival in productivity growth dampens increases in domestic costs and external price pressures fade.”
I took particular interest in the claim that external price pressures will fade. To do so, the global economy would have to remain weak. If so, then it is unlikely that growth in the UK will fare much better, even at the projected “slow but sustained” pace. The other possibility is that the British pound or sterling – CurrencyShares British Pound Sterling Trust (FXB) – appreciates enough that external prices go back down. If so, then Mervyn King’s hopes of rebalancing the economy with a reduction in demand for imports and an increase in exports surely will not be realized.
Adding to this conundrum for the UK economy is the stubborn persistence of weak economic growth (mainly flat) along with strong employment growth. The UK economy is getting less and less productive and thus less and less capable of offsetting inflationary pressures. This is a dynamic that I will be watching ever more closely given the BoE projects a two-year horizon over which the economy will continue to suffer high inflation and weak economic growth (aka stagflation). The implication for the currency is mixed, and I continue to expect “more of the same” for the pound.
On June 15, Bank of England Governor Mervyn King spoke at the Lord Mayor’s Banquet for Bankers and Merchants of the City of London at the Mansion House. The speech covered very familiar themes for King and the Bank of England.
King begins by acknowledging the squeeze on the current economy:
“The challenge facing monetary policy is obvious – the combination of high consumer price inflation and weak economic growth. Both of these might seem surprising given the large amount of spare capacity in the economy. But the rise in world energy and other commodity prices, and the need to reduce both the external and budget deficits, are squeezing real living standards, pushing up on consumer price inflation and slowing domestic consumption.”
Over the years, King has consistently hammered on the theme of rebalancing in the UK’s economy: a transition away from domestic consumption and toward exports and the business investment required to support this shift. King indicated that the rebalancing underway will continue for several more years. This process has necessitated the devaluation of the currency. Interestingly, King cleverly attributes the devaluation to market forces while indicating the Monetary Policy Committee (MPC) chose not to counter-act the pressures on the currency:
“A necessary precondition for that rebalancing was a fall in the real exchange rate. Markets anticipated that need. The nominal effective sterling exchange rate fell by around 25% between the start of the crisis in 2007 and the beginning of 2009, since when it has been broadly stable…
…We could have raised Bank Rate significantly so that inflation today would be closer to the target. But that would not have prevented the squeeze on living standards arising from higher oil and commodity prices and the measures necessary to reduce our twin deficits. And it would have meant a weaker recovery, or even further falls in output…”
In other words, the MPC decided to focus on the implications of a weak economy over the implications of high inflation, judging the former to be the greater threat. In doing so, King has frequently noted that today’s high inflation is temporary, thus rationalizing on-going accomodative monetary policy and low interest rates in the face of high inflation. The primary blame for high inflation has shifted from hikes in taxes (the Value Added Tax or VAT) to commodity and energy prices, both presumably out of the control of monetary policy. Internally, conditions do not exist for sustaining “domestically generated” inflation:
“So far, subdued rates of increase in average earnings, as well as remarkably – some might say disturbingly – low growth rates of broad money have provided strong signals that inflation will fall back in due course. Banks are still contracting balance sheets and reducing leverage. Spreads between Bank Rate and the interest rates charged to many borrowers remain at unprecedentedly high levels, if indeed borrowers are able to access credit at all.”
King really caught my attention when he provided two key conditions that would actually compel rate hikes:
- A pickup in domestically generated inflation
- A contraction in the spreads between Bank Rate and the interest rates charged to many borrowers
Given the dour outlook for the economy and an on-going reblancing in the economy, I continue to assume that rate hikes in the UK are somewhere off in a very distant future. King has proven quite adapt in coming up with reasons for maintaining loose monetary policy, and I continue to see strong evidence that he is reluctant to tighten for fear it could upset the rebalancing he so deeply desires. Indeed, King notes that there is no way to tell when the MPC may hike rates:
“Uncertainty inevitably surrounds both the speed of the rebalancing and the impact of today’s consumer price inflation on tomorrow’s domestically generated inflation. So it is simply impossible to know now at what point monetary tightening will begin.”
In “G-20 Stung by Faster Inflation as Imbalance Dispute Rages“, Bloomberg reports that French Finance Minister Christine Lagarde has added her voice to the growing group of nations concerned about inflation:
“We clearly need to keep inflation at bay…Too much inflation is not going to be conducive to growth.”
While these conclusions are obvious, the remarkable quality of these comments is that they come at a time when inflation remains a concern amongst developing and emerging economies and not the (relatively) stagnating ones of Europe and the United States.
Only time will tell whether comments like these will translate into any changes in monetary policy anytime soon. For example, Governor Mervyn King made it quite clear this week in his discussion of the Bank of England’s Inflation Report, that he has no intention of changing monetary policy anytime soon even with inflation continuing to print well above the Bank’s mandated target of 2%.
Bank of England (BoE) Monetary Policy Committee Member Adam Posen tells CNBC in an interview (see below or click here) that stubbornly high inflation is keeping the Bank of England members up at night. However, Posen prefers this situation to deflation (as all central bankers would). Slack in resource utilization is not having the same dampening effect it is having in other industrialized countries like the U.S. I would think the steady decline in the British pound has a lot to do with the high inflation rate, but Posen claims it is not a sufficient explanation. Note well that this depreciation is essentially what the BoE, or at least Mervyn King, has desired to kickstart economic growth in the UK through higher exports and lower consumption of foreign goods.
The interviewer reminded Posen that the BoE was wrong about its inflation forecast going into 2007, and Posen accordingly refused to get nailed down on any timeline for a rate hike. He did note that if there is no clear inflation shock in the economy, then the BoE will have to assume that inflation expectations are too high.
The Bank of England set the stage for maintaining an easy monetary policy for some time to come in its latest quarterly Inflation Report.
The Bank of England continues to expect a “…a slow recovery in the level of economic activity” partially because “…it is likely that credit conditions will remain restrictive for some time and that the need to strengthen public and private sector finances will weigh on spending.”
Moreover, the BoE maintained its forecast for low inflation for the next three years claiming that “…it is more likely than not that inflation will be below the target [2%] for much of the forecast period, but the risks are broadly balanced by the end.” (The forecast ranges from -1% to 5%).
Given these conditions, the Bank of England will be in no rush to tighten (significantly) monetary policy anytime soon.