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In Denial at the Bank of England

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In Denial at the Bank of England

October 23, 2016

It was said of the House of Bourbon that they learnt nothing and forgot nothing. One wonders whether the same might not be said now about the Bank of England (BOE) given its poor handling of sterling’s post referendum collapse. Despite a series of previous sterling crises, the BOE seems to be disturbingly indifferent to the risks of a full-blown currency crisis or to the serious damage that a very weak currency might wreak on the United Kingdom’s economy.

One has to be struck by the rapid decline of the pound over the past four months. Whereas in June, prior to the Brexit referendum, a pound bought 1.5 US dollars, today it buys little more than 1.2 US dollars. This roughly 20 percent pound depreciation is approaching that which occurred in the wake of the 2008 Lehman crisis and of the 1992 ERM crisis. It also very much exceeds the infamous 14 percent “pound in your pocket” devaluation in 1967.

One perhaps should not be surprised that the pound has fallen like a stone since the referendum. After all, that referendum occurred at a time that the UK was running an external current deficit of around 6 percent of GDP. That was the largest such deficit in the post-war period, which in the words of BOE Governor Mark Carney makes the UK uncomfortably dependent on the kindness of strangers for its financing.

It has hardly helped matters that Theresa May’s new government seems to have opted for a “hard” Brexit by indicating that it is not prepared to compromise with its European partners on the issues of sovereignty and of control over the UK’s borders. This has heightened investors’ fears that the UK might not retain access to the European Single Market. It has also raised concerns that City of London financial firms might not retain their European financial passport, which currently allows them to operate freely in the European market.

One would have thought that by now the BOE would be doing something to prevent further pound selling. This is particularly the case considering how open the UK economy is and how large an effect a fall in the pound could have on domestic inflation. By the Bank’s own calculations, if sustained a 20 percent pound decline could over time increase the UK domestic price level by as much as 5 ½ percent.

One would also have thought that the BOE might be concerned about the risks that inflationary expectations might become unanchored. Underlining that risk is the fact that 5-year inflationary expectations as reflected in the UK bond market have now risen to around 3.5 percent. That is well in excess of the BOE’s 2 percent inflation target.

Far from doing anything to support the pound, by its deeds and words the BOE seems to be giving the market license to keep selling the pound. Not only did the BOE cut interest rates immediately following the referendum, thereby making sterling less attractive. It also kept indicating that monetary policy would be loosened further later in the year. In addition, it seemed to be in denial about the potential negative effect that a further fall in sterling might have on the UK economy. Indeed, senior BOE officials keep saying that they do not consider sterling’s 20 percent drop to be excessive and that they are not concerned about the potential inflationary impact of sterling’s fall.

Equally disturbing, it seems that the BOE is ignoring the fact that the UK’s present circumstances might need a tightening rather than a loosening of monetary policy for two basic reasons. First, the sharp fall in the pound in and of itself constitutes a significant easing in monetary conditions that might need to be tempered by interest rate increases. Second, the fall in the pound indicates that foreigners are no longer willing to finance the UK’s gaping external current account deficit. If that deficit has to be reduced, both fiscal and monetary policy would need to be tightened to make room for the shift of resources to the external sector if the country is to avert a spurt in inflation.

It is to be hoped that the BOE will soon change course and become more serious about the currency’s precipitous decline. If not, the country should brace itself for some rough economic sledding, while the BOE should be prepared to deal with a loss in its credibility.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a Deputy Director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.

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