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COLUMN-BoE's "hawk shock" highlights delicate sterling balancing act: McGeever
June 15, 2017 / 3:50 PM / a month ago

COLUMN-BoE's "hawk shock" highlights delicate sterling balancing act: McGeever

4 Min Read

(The opinions expressed here are those of the author, a columnist for Reuters)

By Jamie McGeever

LONDON, June 15 (Reuters) - The Bank of England gave sterling an instant shot in the arm on Thursday, stunning financial markets by moving closer to raising interest rates than it's been at any time in the last decade.

With the rate of inflation at its highest in four years and showing no sign of reversing, the Bank's eight-strong Monetary Policy Committee voted 5-3 to keep rates on hold at a record low 0.25 percent. Economists had expected a 7-1 split.

But the pound's boost faded, exposing the Bank's delicate balancing act: trying to shore up the currency without delivering the policy tightening that could damage an economy already slowing amid the deep uncertainty of Brexit.

It's a dangerous balancing act, too, one that could put the Bank's credibility in the eyes of financial markets on the line. As the Bank itself knows only too well, once it's lost, it's extremely hard to recover. And the currency suffers.

Turkey's central bank jacked up rates by more than 400 basis points, or four percentage points, in January 2014 to prevent the sliding lira from sparking massive inflation. Later that year, Russia's central bank more than doubled interest rates to 17 percent.

It's not only an emerging market phenomenon, either. The Bank of England famously raised interest rates to 12 percent on 16 September, 1992 - "Black Wednesday" - and spent billions of dollars of its foreign exchange reserves in a doomed attempt to defend the pound from attack.

The Bank is in a bind. Economic growth is slowing, and all the incoming data show no sign of it picking up speed any time soon. Figures released just before the Bank announced its decision on Thursday showed that retail sales in May fell sharply.

On Wednesday, data showed that wage growth in February-April was much weaker than expected at 2.1 percent, while inflation in May jumped to a four-year high of 2.9 percent.

This means real earnings are falling at the fastest pace in three years, throwing grit in one of the economy's most powerful growth engines: consumer spending.

British growth in the first quarter was the slowest of all 28 European Union nations, according to Eurostat. And if the Organisation for Economic Cooperation and Development is right, the 1 percent growth penciled in for next year will be the lowest of all 32 nations covered in its latest outlook.

Against the hugely uncertain backdrop for investment and spending stemming from Brexit, Britain's soft economic indicators point to the Bank sticking with its ultra-loose policy and sterling remaining under pressure.

All bar one: inflation. The pound's 13 percent devaluation since last year's Brexit referendum has fueled the surge in inflation, and there's little sign of it reversing much any time soon.

It's decimating real wage growth, eating into consumer spending and weighing on the economy at large. The growth outlook is darkening, and as Thursday's vote showed, the Bank finds itself in an increasingly tight spot.

If it threatens to raise rates, sterling could steady or even rise in value, thereby easing the upward pressure on inflation. The erosion of real earnings would stop, potentially providing a springboard for a rebound in consumer spending.

This would be the ideal scenario for the Bank. But it only works as long as the $5 trillion-a-day currency market believes that, if the push comes to the shove, the Bank will raise rates. If not, sterling will likely come under immediate and sustained attack.

A fall towards $1.20 would be more on the cards than a test of $1.30 again. In that scenario, with inflation already nudging 3 percent, the Bank's current dilemma will seem like a picnic in comparison. (Reporting by Jamie McGeever, editing by Larry King)

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