Discussion and Analysis by Charles Porter:
The Bank of England’s Bank Rate has been raised by 25 basis points. Strangely, the rate hike forced the Pound Sterling downward. The counter intuitive foreign exchange movements following the Bank’s decision are explained by a combination of the overpricing of a rate hike and a ‘dovish’ tightening. Whilst the first rate hike from a central bank in 10 years might rightly suggest an unmistakably hawkish monetary policy move, the forward guidance undermined a rising cost of borrowing. Upon the news, the Pound Sterling lost an indicative 1% against the US Dollar.
The monetary policy decision was accompanied by an inflation report for the UK economy. The report and press conference indicated inflation expectations within the UK are only likely to return to target within the next two years. Despite excess inflation, the monetary policy decision was accompanied by forward guidance indicating only one rate hike a year for the next two years. This Brexit-led interest rate policy generated impressions that the rather hawkish decision of the Bank of England to raise the rate of borrowing was in fact a dovish event.
The concomitant decline in the value of the Pound Sterling was starkly negative. Following the announcement and the press conference, markets repriced the probability of a rate hike in the future. Extending the curve forward, markets are unable to price an interest rate hike to much over 2% even in the ultra-long-run.
Carney proved the credibility of the Bank by sticking to its forward guidance and, as such, proved himself to be less of the unreliable boyfriend. However, Carney also drew criticism from a wide range of market commentators for a premature and ill-considered monetary policy decision. To understand the fall out within the currency market it is important to understand the complexion of the decision itself.
At face value, a 7-to-2 division within the Monetary Policy Committee (MPC) is a highly confident vote for an interest rate hike. The only two members of the MPC that did not vote in favour of the rate hike are renowned for their dovish attitude towards monetary policy. Whilst the longer standing member, Jon Cunliffe, has a proven voting history and attitude towards lower rates of borrowing, David Ramsden’s persuasion towards the preservation of accommodative monetary policy has only just become apparent.
Taken at face value, a central bank confidently hiking rates for the first time in a decade would tend to appreciate the exchange rate dramatically. Moreover, an inflation rate that is predicted to stay above three percent at least until the end of the year would similarly persuade markets that a further interest rate hike was either imminent or, at least, far from a one-off manoeuvre.
The problem with this impression, and the reason that Sterling faced a counter intuitive depreciation was the source of inflation and the capacity for the real economy to internalise a higher rate of borrowing. The source of inflation comes entirely from abroad, with the deterioration of the exchange rate following the Brexit referendum being the reason for inflated importation prices. The proof for this opinion is the low inflationary pressure that the domestic, inwardly-orientated, service economy is producing.
Therefore, because inflation is ultimately a statistic that measures year-on-year change, eventually the current high price level caused by a persistently low-valued Pound will be compared within a similar state of affairs; the incumbent paradigm of a post-Brexit United Kingdom. This understanding explains the dovish decision from the Bank of England MPC. Their report must not over stimulate British markets that price a higher return to investment and saving when there remains the possibility that before the final secession of the UK, there is under-target inflation within the UK economy.