This past week, the British pound fell to an 11-month low, playing catch-up with the falling euro. Just six months ago, the pound was the shining star among major currencies. But now, pressures from the weak eurozone nations are weighing on the U.K., dragging its inflation rate down to a near five-year low.
Right after the Lehman Crisis of 2008, the Bank of England (BOE) was actually one of the first central banks to avoid deflation by adopting large-scale quantitative easing. Indeed, in the years 2010 and 2011 its inflation rate was above 3%; more than 1% above its 2% target. This was in part due to the increase in its sales tax from 17.5% to 20%, and although inflation started to dwindle after that one-time effect from the tax hike, the U.K. economy was still recovering. As recently as this past June, current BOE Gov. Mark Carney said that Britain may have to raise rates sooner than the market is expecting. Immediately, investors bought the pound, taking it to a five-year high, thinking that the U.K. would be the first of the advanced nations to raise rates. Now it appears that might not happen for close to another year. The market now thinks the BOE will not raise rates until late 2015. Investors had to get out of their long-term pound positions, resulting in the recent sell-off.
Not only that, last week Gov. Carney hinted that inflation may slow to less than 1% in the coming months. That’s less than half of its 2% inflation target. In the U.K. when inflation diverges more than +/- 1% from the government’s target, the BOE (commonly referred to as the Old Lady) needs to write a letter to the Chancellor of the Exchequer, explaining why inflation has wavered – a requirement designed to ensure that both monetary and fiscal policies are in sync. Back in 2010 and 2011, former Gov. Mervyn King had to write to the chancellor repeatedly, explaining why the inflation rate was persisting above 3%. This time, however, Gov. Carney’s letter will have to explain why it’s languishing.
My View: It’s very difficult to gauge inflation in today’s volatile economy. It does seem that there are more false alarms on premature inflationary symptoms than there were in the past – so much so that even prominent policy makers have been tricked. Nonetheless, the U.K’s economy is still stronger than the rest of Europe. Let’s hope it finds its footing again soon.
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