I have followed the Bank of England's quarterly Inflation Report since November, 2009 as a way to gain insight into the UK economy and the prospects for the British pound (FXB). The latest report was released on May 16, and it contained some notable perspectives I have not noticed in previous reports on inflation, the currency, and economic output.
Extended commentary on the need for economic rebalancing in global economies builds upon familiar themes and warnings and has taken an even greater urgency given the on-going sovereign debt crisis in Europe. This Inflation Report left me once again with the impression that British pound (or sterling) has little to no chance in the near-future to sustain any across-the-board appreciation and nor (re-)achieve "safety currency" status.
I think this was the first occasion in which Bank of England (BOE) officials admitted that the higher rate of inflation has surprised them because historical relationships did not repeat themselves as expected. In retrospect, they indicated they were overly swayed by the experience of the early 1990s when currency depreciation did not pass through to substantial domestic inflation. Instead, the current pass-through is similar to what happened in the 1970s and 1980s.
In addition to the 25% depreciation in the British pound, the BoE pointed to the usual suspects of higher oil and other commodity prices (which of course are themselves exacerbated by a depreciated currency) and an increase in the Value Added Tax (VAT) as drivers of an inflation rate that remains stubbornly well above target. Suppressed wages have acted as a small brake against inflation. The BoE believes that futures prices on gasoline indicate relief is on its way for the take-home pay of British consumers, but reporters in the audience sounded understandably skeptical. The BoE has promised relief around the corner many times before.
Despite the currency's contribution to inflation, the BoE sees this dynamic as a necessary evil in accomplishing a rebalancing of the economy away from domestic demand and toward more exports. While they admitted that central banks cannot expect currencies to behave as they would like (are you listening Swiss National Bank?), they believe the benefits of depreciation remain intact for the United Kingdom. This rebalancing includes a gradual tightening of fiscal policy and loose monetary policy (low interest rates and quantitative easing through asset purchases). The BoE proudly declared that few countries are facing up to these challenges as the UK is doing. For example, Germany and the Netherlands have yet to face up to their own need for rebalancing.
The UK's rebalancing has become more challenging given the on-going woes within the borders of its largest trading partner, the eurozone. The BoE has very low expectations for prospects in the eurozone. By extension, I have to conclude that economic prospects in the UK are similarly subdued. The Inflation Report includes the following commentary on this subject (emphasis mine):
The prospects for UK growth remain unusually uncertain. The single biggest threat to the recovery stems from the challenges within the euro area, in particular the need to reduce the indebtedness and improve the competitiveness of some member countries. Even if a credible and effective set of policies is successfully implemented, the scale of the necessary adjustments suggests that a prolonged period of sluggish growth and heightened uncertainty is likely. A failure to implement such policies could have severe implications for the UK economy.
In other words, it remains hard to imagine that the British pound can appreciate much, except perhaps over the euro, in the near-term. Earlier talk about the British pound serving as a safety currency were certainly squashed during May has it nosedived against the U.S. dollar and Japanese yen. I was not surprised to read several days ago that IMF managing director Christine Lagarde thinks the risks to the UK economy are large and to the downside, concluding that BoE should implement yet another round of quantitative easing (QE). More QE should of course place even more pressure on the currency - unless the current plunge is all about pricing in an imminent increase in QE.
The pound has dropped 6.1% versus the U.S. dollar over the past month, retesting the bottom of a wide trading range
The pound has fallen against the yen since April
Governor Mervyn King as been one of the most ardent promoters of the need for rebalancing within the United Kingdom and across the global economy. In answering a report's question, he took one more opportunity to complain about events in the eurozone:
What is so depressing about it is that this is a re-run of the debates we had about the banking sector in 2007/08. These are not liquidity problems; they are solvency problems. There are big - the imbalances between countries in the euro area have created creditors and debtors, and at some point the credit losses will need to be recognized and absorbed and shared around. And until that is done, then there will not be a resolution of the problem. And that is why just kicking the can down the road is not an answer. The European Central Bank has performed heroically in trying to buy time, but that time hasn't been used to put in place underlying fundamental solutions.
King went on to state that survival of the euro is not the real issue. Instead, the real issues are the imbalance in competitiveness, external deficits, and trade surpluses. This rebalancing must include the recognition of credit losses. Despite all the wrangling over the past two years or more, there remains no credible path to achieving resolution. King's frustration showed as he wrapped up this commentary by stating "I will do no more shouting. I will simply rest where I've made that point; others now have to respond."
Spare capacity is typically considered another indicator of the performance of an economy. When production capacity is highly utilized, an economy tends to grow and prices tend to increase along with higher demand for resources and labor. Higher wages contribute to increased demand for goods and a virtuous cycle appears. When production capacity is left fallow, this cycle works in reverse as unemployment increases, wages decline, and economic growth stagnates. (Your perspective may depend on whether you think demand drives supply or supply drives demand).
The output gap measures the difference between what the economy could theoretically produce and what it is actually producing. In this conference call, the BoE claimed it cannot determine the spare capacity in the economy and thus cannot measure the output gap. King specifically stated that people are spending too much time trying to determine whether the UK has permanently lost capacity. Different surveys on capacity have provided contradictory answers, but the BoE guesses that it could take 10 to 20 years to return to pre-recession capacity and utilization levels! They also do not expect to be able to step on the "accelerator" in order to use up spare capacity and expand output over the next 2 to 3 years.
There is certainly little room for cheer in the assessments of the Bank of England. The icing on the cake was the BoE's discussion on uncertainty and risks. The BoE has emphasized over and over that its forecasts and assessments include a wide band of uncertainty. This time, King provided an even more extended explanation for properly interpreting economic analysis, confidence intervals, and statistics. He provided a framework for assessing the quality of decisions:
Forecasting is not about producing a number. It's not a spot the ball contest where you say 2.7 or 3.2. The most that you can hope to do - and we've been very open about this for 20 years - the most that you can hope to do is to assess the balance of risks. Inevitably, if you take a forecast as a point forecast, with probability almost one, it will turn out to be wrong. The question is - what do you see in the data and does that change your view about the balance of risks looking forward?
So I think the question of whether you should take what we say seriously has to depend not on looking at precise numbers or even at the fan charts, but on - do you think the explanations we give for why inflation has moved as it has are plausible explanations? And do you think that the inferences we draw from those explanations about the balance of risks to the future are reasonable?
If you do, then I think you would say - yes, of course, no one can know the future, but these are reasonable judgements. If you disagree with our interpretation about the economic analysis, then you would probably take issue with the judgments we make about the future. But I think what's most important is that whatever debate is had is not in the context of right or wrong, it's in the context - were the explanations reasonable and did they lead to reasonable judgments about the future?
Of course, this explanation frustrated some of the reporters in the audience who want to hold someone accountable for being wrong or right about policies and forecasts based on outcomes. Moreover, given the large amount of uncertainty, there is also a wide opportunity for making assessments that appear reasonable. Indeed, the BoE warned the audience that it should not think of risk in the same way as they did before the recession. Given the tremendous and historic economic trauma of the past several years, it does not make sense to "…pretend that the risks…are easily calculable in terms of quantitative probabilities."
Accordingly, I think it does not make sense to forecast the direction of the currency beyond the ripple effects of the latest catalyst. As the pound plunges toward the bottom of trading ranges, the next question is whether the pound can once again find enough buyers to bounce it from lows (against the U.S. dollar and Japanese yen) or whether current economic uncertainties and fears have grown strong enough to push the currency ever lower. Until the next catalyst appears, I am assuming the prevailing weakness will continue. The Bank of England certainly gave me plenty of reason to stay comfortable with this assumption.
In the meantime, be careful out there!
Disclosure: I may initiate a short position in FXB over the next 72 hours.
Additional disclosure: In forex, I am short GBP/JPY, EUR/GBP; long GBP/AUD.