Bank of England Minutes and a Little Background History

May 18, 2011

When the Monetary Policy Committee last met on May 4-5, policymakers found the inflation outlook no clearer than before and voted in the same highly fractious pattern as they had at the previous three monthly meetings.  Uncertainty is compounded by two conflicting forces.  Cost-push inflation from raised indirect taxation, elevated commodity prices and previous sterling depreciation had been reinforced by a significant incremental rise of oil prices during the prior three months.  Upwardly revised CPI inflation is now expected to crest at or above 5.0% later this year and to remain above the 2.0% target next year.  On the other hand, the abundance of excess unused productive labor and capital resources caused staff to revise growth projections downward and policymakers to wonder how severely this persistent output gap would depress demand in the medium term.  It was felt that personal consumption would stay weak for quite a while, but business surveys were showing resilience and implied adequately positive economic growth in the future, rather than the lack of any net growth that had occurred between 3Q10 and 1Q11.  A third consideration that was discussed was the impact of above-target inflation, which has occurred since the start of 2010, on future wage demands and other pricing behavior.  Such second-order inflation hasn’t been meaningful so far but could become so, especially if growth in British labor productivity continues to surprise on the downside

Officials disagreed more than typically happens in their individual views about inflation but found continuing consensus in concluding that the probabilities of medium-term above-target inflation and below-target inflation are about equal.  From an action standpoint, that common ground was a continuing recipe for doing nothing new.  Britain’s Bank Rate has been 0.5% since March 2009, and quantitative easing ended fifteen months ago.  The last time that RPIX inflation — the old targeted measure of prices — surpassed 5.0% as now was in early 1992, the fateful year when hedge fund speculators forced the U.K. Treasury to withdraw sterling from the European Exchange Rate Mechanism (ERM).  Britain’s Bank Rate was at 10.5% for the first third of 1992, then reduced to 10.0% in May, but briefly lifted to 15% in a desperate, unsuccessful attempt to preserve the pound’s parities against other European currencies.  After leaving the ERM on September 16, also known as Black Wednesday, the central bank rate was slashed by nine percentage points to 6.0% in just over four months.  Even then, interest rates remained many percentage points above their current levels.  The yield on 10-year gilts has been at 9.46% when Britain abandoned the ERM and at 8.10% in late January by which time the central bank rate was down to 6%.  It is now at 3.37% and only 27 basis points higher than comparable German bund yields. 

Sterling is presently trading at DEM 2.2175 against the synthetic mark, 24.8% below the DEM 2.95 central parity against the German currency when the U.K. was a participant in the ERM.  Sterling/dollar is extremely close to its 2011 year-to-date average level and just 5.5% weaker than its 10-year mean against the U.S. currency.  However, the dollar is not a good yardstick for measuring the strength of currencies, since it has been secularly weak in its own right.  Compared to  sterling highest levels over the past ten years reached in early July 2001, the pound has depreciated 27% on a trade-weighted basis and 32.6% against the euro.  Sterling was whacked badly in the wake of the Lehman Brothers bankruptcy and touched its lowest level for the past ten years in late December 2008.  Compared to then, the pound has recovered 11% against the euro and 7.6% in trade-weighted terms.  Most recently, however, sterling has traded heavily as investors price in Britain’s poor fundamentals such as chronic budget and external deficits, relatively high inflation, weak growth, and loose monetary policy.

Copyright Larry Greenberg 2011.  All rights reserved.  No secondary distribution without express permission.

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