Discussion and Analysis by Charles Porter:
Bank of England: Stop and Think – Please!
This week was dominated by one event and so too will next week. Whilst monetary policy continues to, by and large, rule exchange rates, the Bank of England monetary policy decision on Thursday must be watched closely. Despite a threat to central bank confidence from the inventor of forward guidance at the Bank of Canada, perhaps Dr. Carney should go back on his word and not raise rates.
Inflation within the United Kingdom is uncontrolled and rampant, surely, we have to raise interest rates! At least that’s what the first page of an economics textbook might suggest. In reality, a decision to tighten UK monetary policy on November 2nd could be extremely harmful to both the real economy and the Brexit negotiation period. The jibe above is not to suggest that Dr. Mark Carney is not a learned and intelligent man; by contrast, his successes at the Bank and, for that matter, throughout his career, have been commendable. Suggesting an imminent interest rate hike, however, seems foolish.
The Bank of England is not an extraordinary central bank. It too shares a mandate to control price inflation in the economy. Of course, as the economy overheats and inflation ensues, an increase in the rate of interest encourages saving over consumption, thereby cooling down the inflated economy. With year-on-year CPI inflation registering at 3.0%, according to ONS data released on Monday, the UK is unequivocally a price-inflated economy.
However, there is no domestic inflationary pressure. The rise in the overall price level is almost exclusively driven by an exogenous factor: the exchange rate. The Brexit result from the June 23rd referendum has seen sterling lose approximately 15% of its value, event to date, against the Euro. This has caused a delayed effect of import price inflation, and, therefore, general price inflation that grips the economy whilst reserves and stock are depleted and refreshed at inflated rates.
Therefore, domestic inflationary pressure may no longer be measured by the overall level of price inflation within the UK economy. Instead, by turning to the components of the CPI basket, degrees of exchange rate sensitivity can be isolated to understanding the UK economy. Presented below is overall inflation against food inflation and services inflation. Food inflation, is a basket component that is highly dependent upon importation and, therefore, the deterioration of Sterling’s value. Services trade, by contrast, is less determined by the rate of exchange and the market comprises of a higher propensity for domestic consumption and production.
If there were no domestic inflationary pressure outside of exogenous exchange rate price inflation then total inflation should be explicable by, for example, food inflation alone without a significant correlation to services inflation. Indicatively, above, we can see that this hypothesis is verified. The differential within food CPI inflation, measured by the right-hand axis, is far more significant than steady services inflation. Moreover, the adjusted scale seems to represent a good co-movement of food inflation with overall inflation.
To analyse the relationship between the two components of inflation, the dual graph below models the effect of food and services inflation respectively against overall price inflation. These graphs show that the source of inflation is most likely to be food, and thus import-led, inflation instead of an overheating domestic economy.
For the real economy over the medium-long term, this means that above target inflation is likely to be a fleeting phenomenon. This is a fact that Dr. Carney himself has recognised, but apparently suppressed over his recent appearances. The more concerning spill-over of this reality is that an increase in interest rates will not improve the state of the economy, potentially inviting disinflationary pressures into the future and stunting economic growth. There was a reason that the markets had ‘underpriced’ the probability of an imminent rate hike; markets simply didn’t believe it was a credible or sensible policy option.
If the Bank of England chooses to raise interest rates during either of its November (2nd) or December (14th) Committee announcement dates, then money will still flow to the Pound, raising its value. But only in the short run. The positive effect upon the value of the Pound will be determined by other announcements and monetary policy progressions of, particularly, the FED and ECB.
The race to raise rates between the ECB and the BoE boils down to a first mover signalling advantage. The first hike will, artificially or credibly, signal to the international market that the domestic economy is healing and ready to accommodate a higher cost of borrowing and reward upon investment. However, the long-term effect upon the Pound Sterling could reveal that an imminent Bank Rate hike is a mistake, with no further hikes even throughout 2018 whilst economic growth and inflation struggle to prevail.
Ultimately, speaking as an individual citizen, short term Pound strength is far less valuable to me, than a more stable and long run recovery. Whilst forward guidance central banking may take a hit, the pragmatic policy decision at this time is a no-hike and to allow Brexit progress, genuine domestic inflation, and economic growth to manifest. Call me a Dove, but I hope markets can call Mark Carney one next month.