In a recent article where I discussed the Bank of England being at the heart of the Brexit process, I mentioned how the fall in the value of sterling following the 2016 referendum was pigeonholed by the bank as being the sole cause for inflation breaching their 2% target.
After the article was re-posted by Zero Hedge, a reader commented on something I did not make specific mention of, which was that six weeks after the referendum the BOE halved interest rates to 0.25%, prompting the pound to drop further in value. The reader pointed out that cutting interest rates usually results in currencies depreciating, and that the bank’s actions were the cause of a subsequent rise in inflation and not Brexit itself. Essentially, the premise here is that the BOE were responsible for devaluing the pound and creating the conditions to eventually raise interest rates a year later.
A similar comment from another reader in October last year spoke of how the BOE extending quantitative easing by £60 billion, as well as lowering rates, were ‘two sure fire things to lower the value of the pound.’
Whilst I have touched upon this in previous articles, it is a subject that deserves more attention and fresh context.
Let’s start by first going back to December 2007 when the Bank of England cut interest rates from 5.75% to 5.5%. At the time sterling was valued at $1.96. Two more rate cuts followed in February and April 2008, taking rates down to 5%. The pound remained stable around $1.97. So far the bank lowering rates had not prompted a fall in sterling.
Five months later Lehman Brothers collapsed, and so began a violent downward trend in interest rates. The next cut came in October, down to 4.5%. The chaos within financial markets had fed through to sterling – the $1.97 from five months ago was now $1.72. The BOE moved fast to keep cutting rates under the pretext of ensuring the financial system did not collapse. They trimmed rates in November to 3%, December to 2%, January 2009 to 1.5%, February to 1%, and finally in March to 0.5%.
In the space of fifteen months, rates had fallen by 5%. By the time the March cut was administered, the pound was at $1.41. For the rest of 2009, sterling traded between $1.50 and $1.70 – significantly below the high of $2.00 set on July 23rd 2008.
It should be pointed out that as the BOE were cutting rates, inflation was consistently above the bank’s 2% target for inflation. In the subsequent years following the cuts – notably from late to 2009 to late 2013 – inflation was again above remit. It reached a high of 5.1% in 2011. During this period, the high point for sterling was $1.70 set in August 2009. It otherwise traded between the $1.40 and $1.60 handle.
It was nine months after the last rate cut in March 2009 that inflation began a four year period of being over target. During this time the value of sterling rose, but remained far below pre financial crisis highs.
There is a correlation here of aggressive rate cuts eventually translating into a higher rate of inflation.
Next, let’s go back to the start of November 2015, when sterling was valued at $1.54. Steadily it began to fall as 2016 – the year of the referendum – approached. By the end of December it was $1.47. After falling to $1.38 at the end of February 2016 (a fall that was blamed on ‘Brexit related uncertainty‘), it then fluctuated in the $1.40 range up until the day of the vote.
On June 23rd – the day of the vote – sterling stood at $1.48. It’s value plummeted once the result of the referendum was confirmed. $1.48 became $1.36 in less than twenty four hours, a drop of over 8%. The pound remained highly volatile in the build up to the Monetary Policy Committee meeting at the Bank of England on August 4th (touching a low of $1.28 on July 11th).
After the day the bank lowered interest rates and pumped an extra £60 billion of new money into the financial system, sterling fell 1.65% to $1.31. Two months later, on October 11th, it was down to $1.20. It remained in the $1.20 range until May 18th, 2017.
Here we begin to see a correlation between the Bank of England’s actions and a further sustained fall in the value of the pound. As sterling traded in the $1.20s, inflation broke past the 2% target. A year after the 2016 rate cut and expansion of QE, inflation had risen by over 1.5%.
It was in September 2017, with inflation edging closer to 3%, that the Bank of England began telegraphing an imminent rise in interest rates. Sterling rebounded, touching $1.36 on September 18th. On November 2nd, the bank raised rates for the first time in a decade. Sterling was now firmly back in the $1.30 range, and broke past $1.40 on January 23rd 2018.
On April 17th, its value had reached a post referendum high of $1.43. It was here when BOE governor Mark Carney played down expectations of a interest rate hike in May. Sterling fell back below $1.40 and has so far not returned to this level. When the bank did raise rates in August, the pound remained weak following the BOE’s continued guidance that future rates would likely only be ‘gradual’ and to a ‘limited extent.’
Following the August rise, sterling fell back into the $1.20 range and has since been fluctuating between $1.26 and $1.32, with volatility being blamed on ‘Brexit related uncertainty‘ by the both the Bank of England and the financial press.
We have a situation now where despite the BOE having raised interest rates twice in twelve months, the value of sterling remains depressed. Whilst the media scapegoat the political uncertainty around Brexit as the cause of this, they have failed to recognise a wider trend at play. Communications from the Bank of England, and the words of its governor, Mark Carney, have had a direct impact on the pound. Managing expectations on the path of interest rates, along with stoking up the possibility of a ‘no deal‘ Brexit, has served to keep the currency volatile for an extended period of time.
What is interesting is that the bank’s communications have been reporting for a number of months that the effects of sterling’s 2016 depreciation on inflation are now subsiding. It is through the devaluation of the pound that the BOE have justified tightening monetary policy.
After the high of $1.43 in April, the pound quickly dropped below $1.40 following Mark Carney’s intervention that rates would not be rising in May 2018. Sterling has been below $1.40 ever since. The current price of $1.26 is over 11% down on the April high.
It is a gross over simplification to adjudge volatility in sterling as being solely based on the latest round of political theatre. The Bank of England have proven themselves highly capable of manipulating the trajectory of the pound based on their own communications.
As Britain moves nearer to leaving the EU – possibly under World Trade Organisation terms – the behaviour of sterling could once again have a significant impact on the rate of inflation. In the worst case ‘no deal‘ scenario, the BOE are signalling that the pound may drop as low as $1 – parity with the dollar. A consequence of that, according to the bank, would be inflation rising to over 6%. Prime conditions to carry on raising interest rates.
As discussed before, the global trend throughout the west is for monetary tightening, and to justify this by citing ‘inflationary pressures‘. Those keeping abreast of Brexit developments should not simply be paying attention to the political side, but also the economic ramifications. The longer sterling is devalued, the greater the likelihood of a resurgence in inflation and the rising cost of borrowing.