16 Feb 2011

Five reasons for Merve’s Swerve: from backdoor devaluation to Committee dissent, to not having a clue

Bank of England Governor Mervyn King (Reuters)So what a swerve from Merve at this morning’s Inflation Report.

The Governor of the Bank of England produced an inflation report that made the case for a modest set of interest rate rises this year, confirming a hint in his letter to the Chancellor yesterday, but then pointedly opted to avoid articulating that case himself.

Some people are running ahead of themselves and saying that we are pre-announcing or laying the ground for a rate rise,” the Governor said – a pointed reference to this morning’s front page splash in the FT.

Sterling plunged as he was speaking, as the currency markets had been gee’d up for a green light for rate rises from May. As Alan Clarke, economist at BNP Paribas, said: “While we didn’t get a red light, at best the traffic lights on Threadneedle Street are flashing amber”.

So what’s going on here? The BoE doesn’t know, and to the extent that it does know, it does not agree on the way forward.

1 The clueless BoE

This is not a criticism, merely a reflection that the global sources of inflationary pressure are beyond the Bank’s control. Is it time for a new remit now that global price pressures have turned malignant rather than ten years of cheap Chinese goods boosting living standards?

2 The MPC does know that it disagrees

There is fundamental intellectually-irreconcilable disagreement on this rate-setting committee. Good luck to the soon-to-be-announced new recruit! This should not be surprising at a time of such uncertainty. It should not be surprising when growth is shrinking and inflation is rising. It explains why the Governor played it Betty-both-ways today.

3 Classic Mervyn mass applied psychology

Do not underestimate the Governor. He is conducting mass therapy designed to change economic behaviour – and we are the subject. He has laid the ground. A rate rise is now in the ether. Yes he said that a solitary rise would be an “exercise in futility”, yet he also warned people making long-term financial decisions not to expect rates would stay at 0.5 per cent.

4 Economic wobble

Understandably, the hit to the Bank’s public profile would be appalling if it turned out this was being drummed up in the middle of a recession. My instinct is that they will wait for the Q1 GDP figures in April – and if they show an economic bounceback, we’ll get a move in May. He would never have formally pre-announced it today.

5 Backdoor devaluation

Despite my youth, I have been going to these Mervyn King reports for 11 years now. For most of that period he steadfastly refused to entertain questions – occasionally from me, but mainly The Observer’s Bill Keegan – that sterling’s over-valuation was killing our manufacturing sector. The Bank didn’t comment on Forex issues. Oh how things change. It is difficult for him not to talk about the magic miracle medicine of a weaker pound and its role in “rebalancing Britain”. This is a little-noticed but vital shift in the Bank’s approach. The Bank does not appear neutral on sterling any more. And guess what happened yesterday with the suggestion of rate rises? A considerable appreciation in sterling. And what happened today when he seemingly rowed back? A concomitant fall. I don’t imagine the high fives at Threadneedle Street and at the Treasury will be recorded in any minutes. But remember this. The Government’s entire medium-term economic strategy is dependent on a cheap pound. Ask any manufacturers.

The bigger picture here is, of course, that Central Bank credibility takes centuries to gain – and months to lose.

The Inflation Report does concede that some of the current 4 per cent inflation rate will be passed on in wage settlements. It shows that public inflation expectations are up to about 3.5 per cent. It admits that the trade-off between growth and inflation has weakened because productivity has slumped. So it is perfectly reasonable to ask questions about the Bank’s credibility.

I pointed out to the Governor that his legal remit states that: “Inflation rate will on occasions depart from its target as a result of shocks and disturbances”. Most of the past three years is surely well beyond “on occasions”. He prefaced his reply by pointing out: “You’re very young Faisal”, suggesting that it was much worse in the 70s, when I was a mere econo-zygote.

Many of my Twitter followers thought it was because the young were going to pay the heaviest price. Today’s further deterioration in the youth jobs market suggests an element of truth in that.