Yesterday Bank of England Governor returned to re-occupy ground he had been on only a couple of days before as yet again he promised an interest-rate rise in the UK. At the moment he and Janet Yellen the head of the US Federal Reserve are like twins in this regard. However today I wish to look at it from another impact which is how such talk and promises are affecting the UK in the currency wars which are going on. After the infamous fall in 2007/08 where the previous Governor Mervyn King enthused over a drop of nearly 25% in the UK trade-weighted or effective index the UK sadly gained very little. Now it appears that either Governor Carney is not the sharpest tool in the toolbox or it is official policy to try to talk the UK Pound £ higher which is quite a reversal of policy,especially as it comes after a couple of years of rises.
What did he say?
Mark Carney gave quite a long dissertation on the Magna Carta but then in the august surroundings of Lincoln Cathedral presented himself as an interest-rate seer. He is referring to achieving the inflation target of 2% per annum.
I expect that this will involve raising Bank Rate over the next three years from its current all-time low of ½ per cent.
Indeed he was also willing to tell us by how much.
It would not seem unreasonable to me to expect that once normalisation begins, interest rate increases would proceed slowly and rise to a level in the medium term that is perhaps about half as high as historical averages.
Half of what?
short term interest rates have averaged around 4½ per cent since around the Bank’s inception three centuries ago, the same average as during the pre-crisis period when inflation was at target.
I am not sure if Governor Carney is aware that pre credit crunch 4.5% was considered to be the neutral level for Bank Rate where policy was neither expansionary nor contractionary. Either way he is signalling 2.25% which is slightly lower than his hints in the past. That is not entirely reassuring for a man presenting himself as a seer.
We also got a steer towards the timing of this interest-rate increase promises.
In my view, the decision as to when to start such a process of adjustment will likely come into sharper relief around the turn of this year.
At this point Mark Carney and Janet Yellen look ever more like twins.
Some of this is by now standard as I pointed out only on Wednesday as Governor Carney has regularly and so far incorrectly signalled rises in the official Bank Rate. Accordingly Forward Guidance has been a misnomer and is heading towards being an oxymoron.
What about the UK Pound?
This did get a couple of minor references in Mark Carney’s speech.
The rise in the value of sterling has also played an important role in lowering non-energy import prices, which have fallen over the past twelve months. The sum total of these effects has been to drag inflation below target by around
1½ percentage points.
Also he gave us some numbers on the scale of the UK Pound’s recent appreciation on the foreign exchanges.
Sterling has appreciated around 18 per cent over the past two years and around 7 per cent since the turn of the year.
What he did not do is compare that to changes in the Bank Rate so let me help out on that front. If we look back to the low of March 2013 then we have had the equivalent of a 4% rise. If we look back to the Mansion House speech of June 2014 then the subsequent rise in the UK Pound has been equivalent to a 1.5% increase in Bank Rate. So if Mark Carney ever intended to raise Bank Rate (something I doubt) then the Pound’s strength made it much less likely and perhaps a form of economic suicide.
We have had only a little time to observe events since this week’s two speeches but the UK Pound has been pushed higher again especially against the Euro where we are now approaching 1.44.
Why does this matter so much?
The UK is a small open economy when compared to say the Euro area or the United States. Last October Kristin Forbes of the Bank of England gave us some perspective and numbers on this.
Traded goods and services constitute over 60% of the UK economy. Currency movements directly affect the competitiveness of exports and import-competing domestic firms, and therefore production, employment, and profitability in both of these sectors. About 80% of sales by companies in the FTSE 100 are earned overseas…….About 30% of the main price index is imported goods.
It was also quite revealing that she compared the UK to her home country of the United States and pointed out that a 3% appreciation has been considered relevant there by the Federal Reserve and as she put it.
less than a quarter of sterling’s appreciation since early 2013,
Actually since the 2013 low it is now more like one sixth. If we then factor in that the United States is much less of a trading nation in percentage terms than the UK and that the Federal Reserve is notorious if not for ignoring such effects but downplaying them we get an idea of where we currently stand.
The Balance of Payments
This is an obvious area of concern for the UK as 2014 was a difficult and poor year on this front. From my post on the 2nd of April.
In 2014, the UK’s current account deficit was £97.9 billion, up from a deficit of £76.7 billion in 2013. The deficit in 2014 equated to 5.5% of GDP at current market prices. This was the largest annual deficit as a percentage of GDP at current market prices since annual records began in 1948.
We had a better month this May but that relied on what I consider to be a dubious fall in imported goods unless for the first time in decades the UK is expanding and importing less. It would be nice to think so!
I am not a believer that there is the direct link between currencies and balance of payments in the way that the smooth demand and supply curves of economics text books show. It depends on size of the move and timing and we have to allow for the fact that many goods are price inelastic, however the rise of the Pound is now such that it will be pushing at the inelasticity.
Whatever happened to theories that such trade and balance of payments problems would cause a currency to fall and even plummet? Certainly I can recall periods when much smaller deficits have pushed the Pound lower.
There is much to consider here and let me open with an age-old problem for the UK economy. We are seeing our trading sector being squeezed by a relatively rapid rise in the UK Pound whilst our housing sector benefits from a not only an emergency level of interest-rates but efforts to reduce mortgage rates. So much for rebalancing or “march of the makers”! We are exacerbating rather than improving the position.
It used to be Bank of England policy to talk the Pound down which was summarised by Andrew Sentance with help from the band Genesis.
Selling England by the Pound
Now we face a doppelgänger of this where Governor Carney is talking the UK Pound up. Talk about a switch! Whilst the media concentrate on his hype and bombast about interest-rates I would point out that Bank Rate has been unchanged for over 6 years meaning that the exchange-rate has been the main player in monetary policy for quite some time now. This is true on the international stage hence the concept of Currency Wars. Some may consider that Governor Carney is a cheerleader for the Pound’s rise as he sings along to Kylie Minogue.
I’m spinning around, move out of my way
I know you’re feelin’ me ’cause you like it like this
Personally I was not a fan of the depreciation approach but also after such a rise it seems reckless to try to push the Pound even higher. As the Rolling Stones put it.
You can’t always get what you want
You can’t always get what you want
You can’t always get what you want
Running for cover
Much less reported was the fact that in the Bank Rate rise hype and bombast Mark Carney did cover himself.
As I made clear in my first open letter in February, were downside risks to inflation to materialise the MPC could decide either to expand the Asset Purchase Facility or to cut Bank Rate further towards zero from its current level of ½ per cent.
Cutting below the “lower bound” ,Mark……..