BoE’s ‘hawk shock’ highlights delicate sterling balancing act

The Bank of England (BoE) gave sterling an instant shot in the arm on Thursday, stunning financial markets by moving closer to raising interest rates than it has been at anytime in the last decade.
With the rate of inflation at its highest in four years and showing no sign of reversing, the BoE’s eight-strong Monetary Policy Committee (MPC) voted 5-3 to keep rates on hold at a record low 0.25 percent. Economists had expected a 7-1 split.
But the pound’s boost faded, exposing the bank’s delicate balancing act: Trying to shore up the currency without delivering the policy tightening that could damage an economy already slowing amid the deep uncertainty of Brexit.
It is a dangerous balancing act, too, one that could put the BoE’s credibility on the line. As the bank itself knows only too well, once it is lost, it is extremely hard to recover. And the currency suffers.
Turkey’s central bank jacked up rates by more than 400- basis points, or 4 percentage points, in January 2014 to prevent the sliding lira from sparking massive inflation. Later that year, Russia’s central bank more than doubled interest rates to 17 percent.
It is not only an emerging market phenomenon, either. The BoE famously raised interest rates to 12 percent on Sept. 16, 1992 — “Black Wednesday” — and spent billions of dollars of its foreign exchange reserves in a doomed attempt to defend the pound from attack.
The bank is in a bind. Economic growth is slowing and all the incoming data show no sign of it picking up speed anytime soon. Figures released just before the BoE announced its decision on Thursday showed that retail sales in May fell sharply.
On Wednesday, data showed that wage growth in February-April was much weaker than expected at 2.1 percent, while inflation in May jumped to a four-year high of 2.9 percent.
This means real earnings are falling at the fastest pace in three years, throwing grit in one of the economy’s most powerful growth engines: Consumer spending.
British growth in the first quarter was the slowest of all 28 EU nations, according to Eurostat. And if the Organization for Economic Co-operation and Development (OECD) is right, the 1 percent growth penciled in for next year will be the lowest of all 32 nations covered in its latest outlook.
Against the hugely uncertain backdrop for investment and spending stemming from Brexit, Britain’s soft economic indicators point to the BoE sticking with its ultra-loose policy and sterling remaining under pressure.
All bar one: Inflation. The pound’s 13 percent devaluation since last year’s Brexit referendum has fueled the surge in inflation, and there is little sign of it reversing much anytime soon.
It is decimating real wage growth, eating into consumer spending and weighing on the economy at large. The growth outlook is darkening. If it threatens to raise rates, sterling could steady or even rise in value, thereby easing the upward pressure on inflation. The erosion of real earnings would stop, potentially providing a springboard for a rebound in consumer spending.
This would be the ideal scenario for the central bank. But it only works as long as the $5 trillion-a-day currency market believes that, if the push comes to the shove, the BoE will raise rates. If not, sterling will likely come under immediate and sustained attack.
A fall toward $1.20 would be more on the cards than a test of $1.30 again. In that scenario, with inflation already nudging 3 percent, the bank’s current dilemma will seem like a picnic in comparison.

Source: Arab News