Why the Bank of England Might Talk up the British Pound

If the Bank of England wants to secure economic growth, then it would do well to stoke a recovery Pound Sterling argues a prominent economist.

Pound Sterling’s substantial decline against the likes of the Euro and Dollar following the EU referendum was based on fears about the impact of Brexit on the economy. 

However, one notable silver-lining of the Pound's decline as pointed out by some economists at the time, was the positive effect a weaker Pound would have on exports and therefore the ‘rebalancing’ of our trade relationship with the rest of the world.

However, Bank of England official Ben Broadbent has since suggested the rebalancing expected has not been as great as would be expected as exporters see too much uncertainty linked to Brexit in the outlook to make major decisions.

“Deputy Governor Broadbent observed last week that the magnitude of depreciation experienced by Sterling since last June might usually assist exports and hence drive investment, but that companies are now too uncertain of the implications of Brexit to react,” says Simon Penn, a strategist with UBS in London.

Broadbent’s admission brings into question the underlying drivers in the recent positive run of economic data for the UK, which reached a crescendo in the release of inflation data for February, which showed an above-forecast 2.3% rise.

It tends to strengthen the point made by cynics that inflation is being largely driven by the weak Pound which raises the cost of imported goods, rather than due to ‘real’ economic growth.

A stronger Pound is therefore a key determinant in keeping inflation down and therefore key to keeping the all-important UK consumer spending and the economy growing.

One sure-fire way to a stronger Pound is to raise interest rates.

This of course would have a negative impact on overall economic growth though as it would induce consumers to save and forgo spending.

Penn therefore does not expect the Bank of England to raise rates despite the March meeting proving a great deal more 'hawkish' than markets expected.

The takeaway from the meeting is that if anything, the next move by the Bank will be to raise interest rates.

For Penn, this is perhaps a successful message for the Bank to convey if it helps keep Sterling supported. 

"Sterling is now a key element of the MPC's deliberations. Its hawkish sound bites and the resilience of the economy so far should continue to support the Pound, especially against a Dollar which has been jolted by President Trump's inability to get a new health care bill through Congress, and the associated reappraisal of the US outlook," says Penn.

Talk up the Pound

Penn recommends an alternative more favourable avenue of action for the Bank of England, which would be to talk the Pound up.

“It does, however, suit the BoE's purposes to talk the Pound higher. The removal of some imported inflationary pressure would lessen the risk of a follow-though to faster wage growth. It would also provide support to consumer spending that's already been hampered by a currency cost push – especially important when consumer spending is what's holding up the rest of the economy. But talk is all it will be,” argues Penn.

Thus, don't expect that interest rate rise.

Penn says the Bank is at risk of repeating mistakes made by other central banks who raised rates prematurely, only to have to reduce them again.

This happened when rising oil prices in 2011 pushed up inflation temporarily and encouraged the European Central Bank to raise interest rates twice at the height of the financial crisis, only to cut them again soon after.

Likewise, the US Federal Reserve increased interest rates prematurely in 2015 after it communicated itself into a corner and couldn’t back out without considerable loss of face.

Penn sees a similar risk of the Bank of England doing the same now due to the temporary effect on inflation of the weak pound.

Keeping interest rates as low as possible is a better strategy, says Penn, as it will encourage continued spending and discourage saving, which will promote economic growth.

“The UK has been unable to rebalance its economy, and remains reliant on household spending and the support of the services sector. That may be undesirable, but reversing globalisation or the reworking the global supply chain is far beyond the BoE's remit or ability. As such the central bank will recognise that UK economic growth remains supported by consumer spending and a falling household savings rate,” says the UBS strategist.

Consumer Confidence is vulnerable at the moment, with Gfk Consumer Confidence indicator at -6, from 0 at the time of the referendum.

The index for the economic situation in 12 months' time has dropped to -20, from zero when the referendum was held.

“It might be unpalatable, but a further decline in the savings rate as a consequence of low interest rates should be considered a price worth paying to keep consumers spending and maintain economic stability,” says Penn.

The Time to Talk is Now

The Bank will be mindful of the downside risks Sterling faces over coming weeks as the UK moves into Brexit negotiations with Europe.

“Although the UK has performed far better over the nine months since the EU referendum than had been expected, it's important to remember that all that's happened so far has been a public vote. Brexit hasn't occurred, and it won't be until later this week that Article 50 of the EU Treaty is triggered,” he notes.

What we have seen over recent months reprsents a “phoney war” with the real conflict still to come. Indeed, in this respect the EU Summit on April 27 will be key as it will reveal the EU’s negotiating stance and mark the time of the first real ‘clash’.

Another key risk for Sterling and financial markets will the EU’s initial summit (Ex-UK), probably next week, which will be used to hammer out their negotiating strategy.

Reports from that summit could well cause volatility if they reveal much division or – worse for the Pound – the adoption of a hard-line stance.

Worryingly differences are already cropping up between the UK and the EU just in the way the talks are structured.

The UK wants to conduct a multi-level negotiation, resolving the details of the exit at the same time as those of the new relationship.

The EU appears to favour sequenced talks, settling the divorce bill first before moving onto trading relationships. Article 50 provides just two years to exit. Time wasted squabbling over the order of the agenda will not help the UK's position.

Due to the uncertainty of the outcome of talks the BOE would be prudent in maintaining a ‘wait-and-see’ stance if possible rather than committing to a rate hike before it is ready, says Penn, and in the meantime to use verbal intervention to sweet-talk the Pound higher, thus helping the British consumer, who still is the principle agent of growth.

"If the Brexit conversation becomes acrimonious, or simply bogged down in details, then the uncertainty of the situation will weigh on both the BoE and financial markets. The BoE will try to keep the Pound propped up with talk for as long as it can," says Penn.