The Phaserl


How Not to Manage a Currency

by Alasdair Macleod, GoldMoney:

Make no mistake, sterling’s collapse is a very serious development, and has serious consequences for sterling interest rates.

While it is becoming apparent that interest rates are going to have to rise possibly for all currencies on a one-year view, sterling’s problems are the consequence of bad judgement, and perhaps intellectual arrogance on the part of the Bank of England’s Monetary Policy Committee. The MPC in turn is not and cannot be independent from the influence of Mark Carney, the Bank’s Governor, who made the expensive error of intervening in the Remain campaign.

Many commentators are saying that sterling was over-valued, and the fall will stimulate exports. But value is wholly subjective, and not formulaic, as the ivory-tower economists would have us believe. The idea of stimulating exports through lower currency rates overlooks the depressing effect of the transfer of wealth it triggers from ninety per cent plus of the population, in favour of foreigners and owners of export businesses. That is the point about stagflation.

Do not forget the bank’s stated objective, its mission statement, which is on the front page of its website. It is “Promoting the good of the people by maintaining monetary and financial stability”. Monetary stability is further defined by the Bank elsewhere as “stable prices and confidence in the currency”.

Therefore, this year it has failed spectacularly in its basic mission, as the chart below shows.

The loss of sterling’s purchasing power against other currencies since 1 January has been the least against the headline US dollar, at 17.5%. It has been marginally worse at 19% against the euro, and considerably more against the yen and gold. Unless there is a sustained recovery in sterling in the coming months, the rate of price inflation, irrespective of the outlook for economic activity, will most likely exceed 5% next year. Unilever, for example, is trying to force through price increases of 10% on its range of household and food products. The Bank will be forced to raise interest rates considerably to get price inflation back under control.

Mistakes led to a change in outlook for sterling

It’s worth considering what went wrong, so that we can better assess the future for sterling and the British economy, and to learn lessons that might apply to other currencies as well. Major central bank policies are all driven by the same macroeconomic assumptions, so sterling’s troubles may well be repeated elsewhere in due course.

At the root of the currency problem is an assumption on the part of central bankers that they have primacy over markets. This primacy has become increasingly evident since the breakdown of Gibson’s paradox in the 1975-1982 period, when interest rates no longer reflected demand for savings by business investors. They began to be set by monetary policy aimed at managing consumer demand instead. It marked an economic evolution away from commercial activity in favour of the purely financial, and as that trend gathered momentum, central banks exercised more and more control over the deployment of capital. Notably, governments were able to finance their accumulating deficits with progressively lower interest rates, taking financing costs towards the lower bound.

It is a process that cannot continue indefinitely, because, as the old adage goes, markets eventually reassert themselves. This adage is a summation of all that’s wrong with monetary and financial collectivism, the inability of central planning to allocate capital resources as efficiently as free markets. Sooner or later, a mistake, changing circumstances, or a black swan event leads to a financial or currency crisis. This happens from time to time, and every time the lenders of last resort manage to save their carefully constructed artifices, they say there are lessons learned, and it won’t happen again. Hubris.

Mark Carney made a definite mistake. It was exacerbated by a change of circumstance, but was not a black swan event. As one of the world’s most respected central bankers, Carney apparently believed he had the authority to frighten the British voter into rejecting Brexit by threatening an economic apocalypse. His public utterances ahead of the vote ensured sterling would crash, and financial markets with it, when the vote went Brexit’s way. That event in June is clearly reflected in the chart above. Having dug himself into a hole of his own making, Carney then dug even deeper. Despite all the evidence to the contrary, he continued to believe his own propaganda, that the consequences of Brexit would be dire on a medium-term view. Without waiting for confirmation, the BoE cut interest rates and announced a further round of bond purchases.

Sterling is taking it on the chin. Such is the groupthink in the Bank and in the City that there was no one credible with the sense to advise caution. Large financial corporations are still lobbying furiously for a quasi-remain solution to Brexit, with continuing access to Europe’s broken financial system. Ergo, if they are threatening to move to Frankfurt, Paris and now even New York, the outlook for Britain must be bleak.

Doubtless, Carney and Co. will continue to blame Brexit for sterling’s accelerating collapse, as well as rogue traders (viz. the flash crash last week). The problem with hubris is the blame always lies elsewhere.

The Prime Minister and her Chancellor have also been unhelpful. At the Conservative Party conference greater economic intervention was promised, and the Prime Minister herself stepped over the boundary of the Bank’s independence by criticising QE. The Chancellor’s remarks, perhaps reflecting the opinions of his officials, were similarly unhelpful for sterling, and it has since emerged that Treasury civil servants are trying to subvert Brexit, fearing loss of tax revenue.

Investors and traders now have to contend with a sharply different market environment. Referring back to the introductory chart, it is clear the best performing money for hapless Brits has been gold. Gold has risen this year, priced in all the major fiat currencies, which tells us that commodity inputs to price inflation around the world are turning positive. This is confirmed by the following chart, based on the St Louis Fed’s Producer Price Index for All Commodities, adjusted by the sterling exchange rate, and indexed to October 2011. The implied inflation rate, smoothed over four quarters, is the red line plotted on the right-hand scale.

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