London Calling

Eran Peleg, CIO November 6, 2017

The ice age is coming, the sun's zooming in

Meltdown expected, the wheat is growing thin Engines stop running, but I have no fear 'Cause London is drowning, and I live by the river

- “London Calling”, The Clash

The Bank of England raised rates for the first time in a decade. The last time it did so was in July 2007, just before the Great Financial Crisis. Interest rates were very low since due to the deflationary, weak growth environment we have been in.

On the face of it, you would think that last week’s rate rise is therefore a positive sign that macro-economic conditions in the UK have improved.

Look again. Interest rates are going up because (CPI) inflation has risen to the 3% level, and unfortunately, this recent rise has little to do with increasing demand and an ‘overheating’ economy – but rather, with import prices that have moved up due to the Brexit-driven fall in the British Pound.

UK government bond yields and the Pound dropped on the rate hike announcement. This is quite unusual – typically, higher rates means higher bond yields and a stronger currency. In their response, financial markets are signaling that the UK economy is too weak to withstand higher interest rates. It is a warning that policymakers should pay attention to.

The Bank of England can claim that it is merely doing its job. According to the UK’s monetary policy framework (see: http://www.bankofengland.co.uk/monetarypolicy/Pages/framework/framework.aspx),

the Bank’s primary objective is price-stability. Supporting/promoting growth is only a secondary goal. This stands in contrast to the US, for example, where these two policy objectives are of equal importance (often referred to as a ‘dual mandate’). It is clear that, given current conditions, this framework could lead to destabilizing economic consequences.

Within this framework, it is also determined that if the 2% inflation target is missed by more than 1 percentage point on either side – i.e. if the annual rate of CPI inflation is more than 3% or less than 1% – the Governor of the Bank must write an open letter to the Chancellor (the UK’s Secretary of the Treasury) explaining the reasons for the Bank’s failure in achieving its main goal.

Given that this inflation miss is not the Bank of England’s fault (but rather a direct consequence of the Brexit decision) – just this once, can the UK Chancellor perhaps settle for a polite e-mail or a WhatsApp message…?! If he is concerned about economic stability, rather than focusing on formalities, his time would be better spent on re-thinking the UK’s monetary policy framework.