The pound question
If the Bank of England raises interest rates on Thursday, will the pound rise or fall? Thinking about the answer to that question tells you all you need to know about the series of bad choices confronting our central bank.
In normal times, banks raise interest rates to stop inflation, which they expect to result from the economy growing faster than its long-run sustainable rate. A rate hike is thus a sign of economic strength. Assuming other central banks don't raise rates at the same time, you would expect investors to buy sterling in hopes of (relatively) higher returns and faster growth.
As any foreign exchange trader would tell you, the currency market is not always so logical. Currencies can swing wildly, without central banks doing anything at all. But for most advanced economies, most of the time, you can expect relative interest rate expectations to play a large role in determining which currencies go up in any given month, and which go down.
Many in the markets seem to believe the usual rules apply today: the pound has been rising in recent weeks, on the expectation that the Bank's Monetary Policy Committee will have to tighten policy sooner than previously expected - because of continued overshoots in inflation.
But, thinking about what an early interest rate rise would mean, I wonder would that really be a good time to buy sterling? As I said earlier, rate rises tend to be associated with stronger currencies, because rate rises also tend to go with rising incomes and strong(er) economic growth. But that is not the case here: if rates went up on Thursday, it would be in response to price pressures that have squeezed real incomes and might even threaten the recovery. It would be hard to see higher rates as a sign of economic health.
This is brought out clearly in a recent paper by David Bloom and fellow economists at HSBC, which has this to say about an early move by the MPC:
"In our eyes this [would be] akin to the MPC raising rates based on higher taxes. If, of course, we saw nominal wages rise as a result of higher headline inflation that deflated the mountain of debt, this would be positive for the economy, and a rate rise on this basis would be [sterling] positive. However, the days of having huge amounts of unionised workers with pay links to the RPI are well and truly gone....
...The reason the UK had to embark on QE is that the normal transmission mechanism of monetary policy had broken down. To suddenly assume all is well and a rate hike is needed is bad enough but to assume this is positive [for sterling] is a travesty."
So I guess we know who ISN'T buying sterling assets in hopes of an early rate rise from the MPC. But to judge by the increase in the currency's value since the start of the year, plenty of investors are doing just that.
The longer that continues, the more difficult things will be for the Bank.
Though he has rarely been so blunt about it, a key objective for Mervyn King and the Bank in this entire crisis period has been to talk down the value of the pound. True, the large fall in the value of the pound since 2007 has yet to produce much of a bump in Britain's trade figures. But when it comes to re-balancing the economy, a weak pound is more or less the only strategy we have. At least the production side of the economy, which produces most of our exports, is now growing faster than anything else. In that sense, a higher pound could threaten the one part of Britain's recovery which is less reliant on the spending by hard-pressed UK householders.
To judge by his recent speech (see blog of 26 Jan), the governor is well aware of the economic risks that above-target inflation poses to household incomes and to growth. He is also well aware of the risks of the Bank raising rates too quickly, to bring inflation down. But to those fears we can now add another: the risk that even the suggestion of higher rates will push up the pound.
My strong sense is that most members of the MPC would not welcome a rate rise in the UK any time soon. The Bank needs more currency traders to take the same view.