Sterling and Inflation

ust a month ago, when the Bank of England surprisingly raised interest rates to 5.25% and UK consumer prices reached 3.0%, the pound raced to a fresh 14 year high against the dollar – hitting 1.9915, thus forcing markets to price in two more possible rate hikes in the months ahead. Fast forward to this week, when January’s key inflation numbers were released and the turnaround has proven to be quite remarkable. Given the time lag required for interest rate hikes to feed into consumer price inflation, it is not credible to believe that the Bank of England’s sudden hike a month ago is the reason for a serious easing in inflation in January. That should come in the months ahead.
Let’s look at the figures: producer input prices down 2.0% since December and down 1.6% from January 2006, the annual rate of producer output prices in January eased from 2.2% to 2.1% (obviously cheaper inputs are not resulting in cheaper product for end customers), the annual rate of headline consumer prices eased from 3.0% to 2.7% in the month to January, core consumer prices eased from 1.8% to 1.6%, retail prices eased from 4.4% to 4.2%, wage inflation including bonuses eased to 4.0% from 4.1%, manufacturing units costs down 0.2% in the 3 months to December etc.
February’s Inflation Report suggests that UK inflation will not moderate back to the target 2.0% rate without one more interest rate increase, which oddly enough the report states will not occur until the second quarter. Does this mean further tightening is off the agenda for the Bank of England in March? Apparently so, unless perhaps February’s consumer price data moves back up towards December’s levels. One might wonder, why, if the MPC are so sure inflation will not moderate without one more rate hike, they do not just hike rates in March. Why wait? The MPC are obviously not at one on this question and those members that voted for rates to remain on hold in January will now feel vindicated by this week’s data.
Sterling has largely been in a state of confusion this week, with markets unsure as to whether the currency should be moving up or down. Sterling fell to 1.94 Tuesday against the dollar after that surprising drop in consumer prices, only to jump to 1.9650 Wednesday, following publication of the Bank of England Inflation Report and a broader dollar retreat. We should witness a continuation in the recovery of the euro against the pound though, as the extent of future tightening and interest rate differentials would now seem to firmly favour the single currency, following this week’s data.

The ECB & BoE

The Central banks of the two European majors meet again this Thursday and the markets wait anxiously to see if either party is going to pull any rabbits from the hat this month.
ECB President – Jean Claude Trichet, surprised many in January when he failed to signal a rate rise for the Bank’s next meeting in February. That effectively means rates will stay on hold this Thursday. The market does however expect Trichet to resurrect the word ‘vigilance’ this week, which is a coded signal to the market for a rate hike when the MPC are to meet again, i.e. in March. However, if one looks at the data over the past month, which has been largely mixed, then the market could find itself surprised again Thursday, because there is ample justification for the ECB to hold out for longer. The crucial ingredient is consumer price inflation. Last week, Eurostat published January’s euro zone inflation estimate, which came in flat for the third month running, with an annual rate of 1.9%. Economists were expecting a rate of 2.1%. As the annual inflation rate of 1.9% is inside the ECB’s tolerance level of 2.0%, the ECB will be accused of being heavy-handed if it raises rates again against this inflation background. That in essence rules out any remote possibility of a rate hike this Thursday, but it also raises the possibility that the ECB may choose not to signal a rate hike for March either, giving it an extra month to assess fresh data. While concerns over money supply have been heightened, as M3 money continues to grow, many key business sentiment indicators have softened in the past month, indicating that growth may already have peaked. There is also the problem of the widening diversification problem between the performance of the German economy and the other major economic blocks that make up the euro zone. Against a platter of mixed signals and unknowns, the most sensible course of action for the ECB may be to wait another month and thus to deliver the same message to the market this month, as they did in January. It will be embarrassing to signal a hike now for March, if data were to dictate a different outcome later.

As for the Bank of England, their ability to surprise markets has left many with deep scars in recent months and nobody dare assume the outcome of Thursday’s meeting until the actual rate announcement itself is published on the Bank’s website. The closeness of last month’s vote, when the Bank voted to raise rates unexpectedly by a 5-4 majority, gives some insight into the difference of opinion within the current Committee. Wile debate may be seen to be healthy, the fact that the Bank’s Governor failed to deliver a more decisive vote, points to serious problems with his ability to influence the committee’s other members, which must be a major concern for the Government. To resort to having to surprise financial markets once in 6 months might be construed as a necessary evil, but to do so twice in that period signal something much more worrying. Most economists expect rates to remain on hold this Thursday, but financial markets are not so sure, with many participants deciding to err on the side of caution. It can be assumed that the 4 members who voted to keep rates on hold last time round will do so also this week, so it will only take one of the other 5 to vote with them, to maintain the current rates. What the market does not know however is what January’s inflation figure is. The MPC will have access to this data as they deliberate on their decision. It is wholly unsatisfactory that critical inflation data is not published prior to the BoE’s monetary policy meetings and this coincidently is the principal reason why markets are so susceptible to surprise rate hikes. Had markets gotten print of the 3.0% CPI figure in January, prior to a rate announcement, then financial markets would have priced in a high probability of a rate rise in January, rather than February. Economic data out of the UK has, for the most part, been firm over the past month and the danger must be that inflation will not have dissipated at all, but in fact it may have appreciated again. Against this backdrop and given he market has fully priced in a rate hike for March, could the MPC hike rates again this week? December/ January is a traditional spending time of the year for UK consumers and house markets are in non-seasonal mode, so it might be premature for the MPC to rise rates so quickly again. Indeed, the real impact of both the November and January rate hikes could take a few months to impact on economic data, so a further hike now could seriously damage the economy in the medium to longer term. But given the MPC’s recent track record, should we be surprised?

The Incredible Shrinking Yen

Much has been documented of late with respect to the demise of the currency of the world’s second largest economy. The Japanese yen currently stands (30 Jan) at a 4.5 year low against the US dollar, has been hitting all-time lows against the euro almost on a weekly basis for the past 6 months and last week touched a 14 year low against sterling. In the past 18 months, the euro has gained 18.7% against the yen, while the pound has gained almost 20% in the last year alone. While Japanese authorities have been the first to cry foul about the failure of the Chinese yuan to appreciate, they have been deafening in their silence in response to the virtual collapse of their own currency. Why? Much of the blame for the yen’s depreciation can be put at the door of Japanese political figures that constantly undermine both the currency and the independence of their own Central Bank. Japanese politicians have long had a strategy that a weaker currency is in the best interests of their country with Japan being a predominantly export-oriented economy. In exchange-rated trading terms, the yen registers as the most under-valued currency of all developed countries right now. Yet Japan has a current account surplus the envy of the world and year-on-year trade surpluses registering 40%+ increases are not uncommon for the country. So why is the currency in freefall? I offer 3 major reasons, in order of significance.
1) Carry Trades --> Because Japan has such low interest rates (0.25%), traders have been funding investments in other higher yielding securities and currencies using the yen. The sheer volume and extent of the carry trade appears to have grown increasingly in the past 6 months. One has only to look at the performance of the Swiss franc in the same period to realise that this is not purely a yen phenomenon. It is interesting to see how easily good economic news out of Japan is dismissed so quickly by the market, against how easily the yen is sold off when economic data is not so good. The underlying fact is that the yen is being used to fund investments elsewhere and those borrowing the yen to fund these other investment s are going to continue to do so as long as they can get away with it. The global carry trade is now so heavy that it is going to take some significant event to dislodge the weight of short positions currently held against the Japanese currency. If the authorities that be (Central Banks and Governments) leave the fate of carry trades to such a major event, then a single major issue could lead to a sharp unwinding and collapse of the carry trade that could wreak havoc for financial markets.
2) Domestic consumption --> The principal reason why the Bank of Japan has been unable to raise Japan’s low interest rates is because the Japanese domestic economy remains rather brittle. The Japanese consumer is simply not spending money and domestic demand is stagnant. While wage growth in Japan may have been modest in comparison to some other countries, spending has actually been in decline. Prices have hardly increased, because Japanese retailers are competing for a smaller pot of cash. We could in fact see consumer prices shift back into deflationary mode over the next few months, something that could stall indefinitely any prospect of the Bank of Japan raising rates. This in itself does not explain the current low value of the yen as the Japanese economy has been in this sort of domestic economic predicament for much of the past number of years. But it serves to demonstrate how dependent Japan is on its export industry and why the Japanese Government are not complaining too much about a weak yen.
3) Bank of Japan --> The Bank of Japan has the least credibility of all the major Central Banks right now. The recent debacle regarding the ‘no rate hike’ in January diminished their reputation even further and their independence has largely been called into question. The ongoing interference from Japanese politicians, airing their public opposition to rate increases, highlights the fact that in Japan, monetary policy tends to be as much politically as economically driven. Add to this the poor communication that exists between the Bank of Japan and financial markets and you have a recipe for trouble. Much of the muscle behind the carry trade in recent months has come directly from the perceived weakness and willingness of the Bank of Japan to react in any way. The euro’s uninterrupted ascent against the yen since last summer reveals an unusually one-sided and worrying trend amongst two major currencies. The Bank of Japan has thus far failed to address the weak yen issue at all, let alone do anything about it. The truth is that it may be powerless to do so, as it appears gagged from a fear of offending the government. Recent comments from Japan’s Minister of Finance who dismissed the issue and said that the yen’s current value reflects economic fundamentals give an indication of where the Government sit on the issue. The Japanese Government seem happy to tolerate a weak currency to grow exports, but they are playing a dangerous game. With the failure of the either the Japanese Government or the Bank of Japan to act, it may be left to other global players to address the worrying imbalance.