As Mark Carney talks up the UK Pound can the UK economy cope with it?

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.

Comment

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.

Spinning around
Spinning around
Ohh

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……..

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29 thoughts on “As Mark Carney talks up the UK Pound can the UK economy cope with it?

  1. Hi Shaun

    Great article as always. Do you think this is the BOE’s hidden agenda of targeting wage inflation kicking in?

    thanks

    • I certainly have always thought that the BoE inflation target was always wages but they could not admit to it

      hence a buff and bluff

      Forbin

    • Hi Anteos and thank you.

      Yes it is except they are no longer sure what level to target! In essence wage growth is meaningless without productivity growth which is uncertain. As far as we know it looks like it has picked up too as hours worked have fallen a little whilst output has risen.

      So Mark Carney could quite easily do another u-turn.

  2. For what is worth, here is my view on Foward Guidence on interest rates, they may go up, they may go down or they might stay where they are, depending on what happens – can I have my Governor of the B of E’s salary now please?

  3. Thank you for your cogent analysis of Governor Carney’s speech, Shaun. I noticed that the speech makes reference to “CPI inflation excluding food, energy, education, alcohol, tobacco and VAT”. This is not listed among the exclusion measures for core inflation in Graeme Chamberlin’s 2009 ONS article “Core inflation”, nor can it be found as one of the CPI series in the Time Series Dataset with the monthly CPI release. None of the exclusion measures in Table 1 of Mr. Chamberlin’s paper exclude VAT or any other tax.
    The core inflation measures that have served as the operational guide for the Bank of Canada (CPIX and CPIXFET) work from a CPIXT frame, i.e. they start with the CPI excluding changes in indirect taxes and then proceed to exclude eight volatile items in the case of the CPIX and food and energy in the case of the CPIXFET. (CPIX replaced CPIXFET as the operational guide in 2001.) It would seem to me it would be better for the Bank of England’s exclusion measures of core inflation to similarly work from a CPI-CT frame, only excluding food, energy or whatever after that. The ONS CPI-CT series is much better constructed than the Bank of Canada’s CPIXT series, so it seems strange that it hasn’t already been used as a frame for building up core measures.

    • “CPI inflation excluding food, energy, education, alcohol, tobacco and VAT”

      doesn’t it also ignore housing , well atleast any real measure of it

      and also anything else that goes up in price ?

      It s not called the “Creative Price Index ” for nothing

      and includes such imputed ( meaning what ever it means at the time it is used ) items as sex and drugs ?

      CPI is a joke , so much so that HMG pensions use RPI and so do tax increases

      Forbin

      • Yes, the CPI does exclude owner-occupied housing, except for basic maintenance repairs. Actually, except for that omission, it is basically a good measure of inflation measure for central bank use. Adding an OOH component based on the net acquisitions approach and it would be a very good measure.
        However, I completely agree with you that neither it nor the CPIH is a good index for uprating purposes. The RPI or the RPIJ would be much better.
        These core measures are mostly intended for central bank use, not for uprating purposes. Why would anyone exclude food or energy from an index used for upratings, since everyone needs to eat and to heat their homes?

        • Andrew,

          CPI = Creative Price Index

          It means garbage in = garbage out

          Food, fuel and housing costs are the main burden on the proles ( that means me) as you point out

          CPI is one of these academic la-de-dah measures , like the church debating how many angels you can get on a head of a pin

          It time we stopped this lunatic obession with CB s and sacked the lot of ’em ! ( well proscecuted )

          But I know we are governed not by the people but by the Banks

          Forbin

        • Hi Andrew

          What is your view on the proposed Household Inflation Index that was discussed at the Royal Statistical Society on Monday? There is plenty of scope for using it as an uprating index once it is fully fleshed out…

  4. Hi Shaun

    I think you are a little inconsistent here; if the effect of the depreciation was, in your view, less than might be supposed and there is no direct link between a currency and the BOP ( a perfectly reasonable view), why should this not apply to the rise (“it seems reckless to try to push the Pound even higher”)? Or is there some hidden asymmetry here that you are alluding to?

    As to what MC says he is, to me, trying to put fear into lenders and borrowers without having to actually do anything, to take the heat out of asset markets. I have said this before: I think we will get a recession before we get a rise in IRs and, in that case, we won’t be able to put them up and we’ll be back to square one. Yellen is in the same position and why people bother to parse every utterance they make is beyond me because as the immortal Bard once said – more or less “it is sound and fury signifying nothing”.

    • Hi Bob J

      I liken the 2007/08 depreciation of the UK Pound to like flooding a carburettor as we then had Bank Rate cuts and then QE. If one converts to Bank Rate terms we had something like a 12/13% equivalent. But much of this washed in as economies around the world lurched downwards and by the time that was over at least partially then the UK had done its best to erode any competitive advantage with the above target inflation. So it was a complex mixture and one of the reasons why I argued back then that it would be better to control rather than overlook the inflation rise.

      On the other side of the coin with the current appreciation we have less of a supporting cast. Also the mix is unfavourable and what I mean by that is we have risen if we take the case of the Euro disproportionately against the currencies we trade with. Also I liken what happens to a brick attached to elastic for ages nothing happens and then clung! I fear we are around that area now or approaching it.

  5. Shaun, I recall working for several diverse British companies in an advisory capacity on exports at a time when the Euro was 1.5 to the pound and it had no detrimental impact on exports to the Eurozone. I can’t comment on its effect in other markets but certainly it was not a factor for exports to Europe which did extremely well. Once the slump in Europe arrived, and with it the much lower value of the pound, we couldn’t give products and services away! The Eurozone contraction had a far greater effect than the high value of Sterling. As the UK is essentially driven by imports there must be a value of Sterling that helps reduce our trade imbalance but doesn’t overly hit exports. I wonder what that value is? I also wonder to what extent the current Euro /£ rate results from a weak Euro rather than a strong pound.?

    • Hi Pavlaki

      I am pleased to read that an exchange rate of 1.50 versus the Euro did not damage our exports back then. However since then we did let the inflation genie out of the bottle and only put it back for a while with the lower oil price. so now we are likely to be in an inferior position.

      Back when the media and HSBC were predicting a £ crisis ( parity versus the Euro) I remember sticking up for the £ and arguing that a bit of an appreciation would be a good thing for inflation etc.My issue now is that we could have too much of it especially if the markets and the ECB get their wish and have parity between the US $ and the Euro.

      What we don’t need is for the Bank of England to push us even higher as exchange rates and the £ in particular do have a tendency to overshoot.

  6. Since Sterling has appreciated so much, and since we import so much, it follows that, to have an inflation rate of 0, the prices of domestic goods and services must really be rocketing.
    Either that, or the proclaimed currency-fluctuation/price fluctuation effects are so much more bullshit.
    How much has the price of a German car reduced in the last two years? 18%?

  7. “At this point Mark Carney and Janet Yellen look ever more like twins” – I don’t see it Shaun – wait and see what Yellen says in September/October as I’ve been saying for 6 months now.

    “Whatever happened to theories that such trade and balance of payments problems would cause a currency to fall and even plummet?”

    I don’t believe the link was ever there except in the minds of traders. The current generation have forgotten that part of the textbook, preferring to use GDP, iflation and interest rates as a guide. Which goes to show a lot of economics is in the mind. I said a couple of years ago the nation could “think itself out of the recession”, you thought I’d been out in the sun too long but look what happened and I see no improved fundamentals now from 2013. A matter of confidence.

    • Hi Noo2

      Don’t forget the July 2012 Funding for Lending Scheme which put a light under mortgages and house prices…

      Back in the day the trade balance was a big influence and of course some may remember eras of more fixed exchange rates and controls. However I think that in assuming that there is no influence at all we have gone too far towards the other polar extreme.

      • Hi Shaun,
        I haven’t forgotten FLS which underlines my point – “I see no improved fundamentals now from 2013.” One of those non improved fundamentals, in fact worsened fundamentals is inflated house prices becoming ever more unaffordable, whilst the other side of FLS – business lending is another failing fundamental.

        In fact the housing issue underlines my point – house prices have increased so people “feel” richer, which makes them more confident which makes them happier to spend/consume.

        I agree the Trade Balance was a big influence on the minds of traders at that time, as I said those traders have gone now and the current crop have forgotten about potential problems from large trade imbalances.

        I completely agree that it’s wrong to think there is no influence from a Trade imbalance, but that influence is imo much less than you seem to think – the past 30 odd years is testament to that. I used to think exactly the same as you but in the end I had to accept the evidence and facts of the last 30 some years.

    • Hi JW

      As we are in Genesis mode today.

      “I will follow you will you follow me
      All the days and nights that we know will be
      I will stay with you will you stay with me
      Just one single tear in each passing year there will be

      I will follow you, I will follow you”

  8. Shaun.
    I’m very sorry to keep harking back to the Greek problem, but I have no other means or contacts where I could ask this question:
    It is easy to see the Greeks’ motivation for passing the proposed bailout deal, (desperation) but what was the Reichstag’s?

    • Hi therrawbuzzin

      I think that some in Germany see it as a punishment for Greece but that the majority just want to kick the can. In particular they do not want to face up to any sort of default on the money which has already been lent to Greece. Maybe someone somewhere actually believes it might work..

      • Shaun, I think you could search Europe with a thousand watt arc light and you still wouldn’t find anyone who believes this latest Greek proposal will work!

      • Thank you.
        It is as I feared.
        The last time Europe was this “united” was 1942.
        Why do Germans feel that they have the right to PUNISH anyone, let alone allies?
        There has been much anti-EU hyperbole, much of which has been nonsense, but by inflicting ruin on Greece, rather than allowing her to default to private lenders in 2010, Germany has shown willingness to turn supposed allies into debt-slave vassal states.
        That’s not Union, that’s Empire.

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