Comments: The dark side of Superpound's rise

“Investors are likely to take advantage of this ample liquidity and the associated easy credit to purchase other assets, driving risk premia down and asset prices up," the BoE said in a February 20th, report for parliament’s Treasury Committee. “In due course, those higher asset prices may be expected to feed through into higher demand for goods and prices, putting upward pressure on the general price level.”

In a speech to mark the tenth anniversary of the central bank’s independence, BoE chief Mervyn King said on May 2nd, “It is unfortunate, if monetary developments are given insufficient attention in the analysis of the inflation outlook. The growth of money and credit may signal in advance of other indicators that the Bank rate is set at a level inconsistent with bringing inflation back to the target in the medium term."

Posted by Minh at July 8, 2007 09:33 PM

Dear David,
You seem to have forgotten that the MPCs target is not 3%, not even 2.5%, but 2%. The CPI figures have stayed in the 2.5 to 3% range, showning no sign of heading back to the target of 2%. This is why the MPC have to be more aggressive in raising interest rates. Your expectation that they should do nothing if the CPI stays around 2.5% does not tally with their task of getting the CPI back to 2%.

Regards,
Gideon.

Posted by Gideon at July 9, 2007 09:57 AM

Hmmm ... I wonder if you've ever come across the idea that there are lags in monetary policy.

Posted by David Smith at July 9, 2007 10:16 AM

"When currency traders assess whether to buy or sell, the pound ticks most of the right boxes."

You're making currency traders sound more sophisticated then they really are. Right now, the only box a currency needs to tick is the one next to the question "are interest rates going up?" Yet markets are fighting fundamentals. It's theoretically very difficult to justify further currency strength.

Higher domestic rates of return are not a justification for further sterling appreciation. As interest rate expectations rise (fall), a currency should appreciate (depreciate) instantaneously to equalize domestic and foreign rates of return, then gradually reverse that move as rates return to a more normal rate. If, as you suggest, rates are close to peaking and markets have already priced in that peak, then there seems to be little currency upside. More signficant, if the MPC is in danger of inflicting overkill, then why would you buy the pound? This all seems a little inconsistent.

But to your credit, you do mention the competitiveness problems that the strong pound is causing. The GEP's study sounds very interesting, but you need only look at the UK's 4% current-account deficit to recognize that sterling is overvalued. It seems to me that FX markets are being extremely miopic. They are driving currencies (not just sterling, also NZD, AUD) to record highs based solely on carry. But this is only possible because volatility is at record lows. As soon as volatility returns (which, with interest rates above 'neutral' levels, can only be a matter of time), these trades will blow up. Then, we could see sterling fall quite dramatically.

Posted by Sell Everything at July 9, 2007 10:40 AM

No, no inconsistency, for two reasons:

1. Though it would be nice if they didn't, the markets take a more aggressive view on UK rates than I do, discounting something like 6.25%. In recent months the MPC has tended to validate the market view.

2. As the piece explains, it is not just short-term capital flows that are buoying the pound, though there clearly is an interest-rate play benefiting sterling at present.

Posted by David Smith at July 9, 2007 11:08 AM

I am glad that finally currency is in feature.

Sub-prime woes in USA will not dramatically cause fewer hikes in IR. The market is small compared to the overall mortgage market to cause any jitters, however there is a human standpoint that can be regretted.

Inflation expectations are the same all over this globalised stage and further IR increases are more likely than not. I would expect the FMOC to restart its hiking activity from the end of this year well into 2008.

The sterling as its politics is the best bet for more investors taking a break from the markets and thanks to MK that he has been able to haul in more pounds than usual. However that outcome he is surely not glad to govern over, a pound that is so strong.

Posted by H.Damani at July 9, 2007 01:29 PM