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On February 7th, The Monetary Policy Committee (MPC) of the Bank of England (BOE) decided once again to peg interest rates at 0.5%. The projections and explanations for inflation most interested me about the policy statement. The BoE projects inflation to remain above the 2% target for the next two years (emphasis mine):

Inflation has remained stubbornly above the 2% target. Despite subdued pay growth, weak productivity has meant no corresponding fall in domestic cost pressures. And increases in university tuition fees and domestic energy bills, largely resulting from administrative decisions rather than market forces, have added to inflation more recently. CPI inflation is likely to rise further in the near term and may remain above the 2% target for the next two years, in part reflecting a persistent inflationary impact both from administered and regulated prices and the recent decline in sterling. But inflation is expected to fall back to around the target thereafter, as a gradual revival in productivity growth dampens increases in domestic costs and external price pressures fade.

So, despite these inflationary pressures, the BoE has decided to maintain ultra-low interest rates. The BoE has been quite consistent in its approach to managing policy around inflation targets. No matter what the explanation or trajectory of inflation, the BoE assumes that eventually inflation will return to target. This assumption relieves the BoE of the awful decision to increase rates to choke inflation only to risk further choking an already moribund economy.

However, the current presumed mechanism for containing inflation presents an economic conundrum. External price pressures will most likely only fade if the global economic growth remains weak and/or the British pound (FXB) appreciates sufficiently to offset imported price inflation. If the global economy remains weak, then it is VERY unlikely that growth in the UK will fare much better. This possibility seems to undermine the case for "…a slow but sustained recovery in both demand and effective supply, aided by a further easing in credit conditions…and some improvement in the global environment."

If the currency appreciates notably, then outgoing governor Mervyn King's hopes of rebalancing the economy with a reduction in demand for imports and an increase in exports will not likely come to fruition. At the moment, the British pound is one of the weakest of the major currencies, second only to the Japanese yen (FXY).

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The pound has broken down against the U.S. dollar

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The pound continues a slow and steady trend downward against the U.S. dollar

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Governor King must delight in the sudden and sharp recovery of the euro against the pound - the eurozone is the UK's major trading partner

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In the last several months, the pound has erased three years of weakness against the Japanese yen

Source: FreeStockCharts.com

Adding to the UK's economic conundrum is the stubborn persistence of weak economic growth (mainly flat) in parallel with strong employment growth. The UK economy is getting less and less productive and thus less and less capable of offsetting inflationary pressures. It is a recipe for stagflation that is sure to persist given the austerity budget in the UK. I think weak economic performance will dominate trading on the British pound more so than the inflationary outlook. However, if at any moment it seems that the UK's inflation gets further entrenched while the BoE is trapped at near-zero interest rates, I am guessing the pound will weaken considerably and quickly. Such a move will of course further increase external price pressures and sustain a spiral that only some resurgence of domestic demand and industry will be able to resolve.

In conjunction with the latest statement on monetary policy, incoming BoE Governor Mark Carney provided testimony for almost four hours, discussing the UK economy and monetary policy. Overall, it seems nothing much will change at the BoE under his leadership. He specifically reaffirmed his commitment to inflation targeting and quantitative easing (QE), cited doubts about the effectiveness of targeting nominal GDP given its reliance on people's understanding in what the central bank is doing, and he reassured the audience that he "cannot envision any circumstance where he would support [helicopter money] as a strategy." "Helicopter money" is a reference to endless printing (and distribution) of money in order to prevent deflation; a term introduced into the policy lexicon by a 10-year old speech by (NOW) Federal Reserve Chairman Ben Bernanke. It is much easier for Carney to declare his opposition to such a strategy when inflation, not deflation, is the current scourge of the economy.

Be careful out there!

Source: The Bank Of England Stares Down A Conundrum On Inflation

Additional disclosure: In forex, I am short GBP/USD.