LONDON (Reuters) - Only a year after throwing caution to the wind to shore up the UK economy following the shock Brexit referendum result, the Bank of England is in a bind.
At the centre of the problem is the exchange rate. Sterling’s plunge since the Brexit vote is fueling the highest inflation in four years. But that very inflation is eroding earnings, squeezing consumers and hampering growth.
If the Bank keeps policy loose to ride out the economic slowdown, it risks triggering another slide in sterling and subsequent jump in inflation.
If on the other hand it tightens to curb inflation, it risks hitting consumers and homeowners where it hurts.
Or maybe there’s a third way. The Bank’s Financial Policy Committee on Tuesday raised capital requirements for UK banks to tackle the growing risk of lax lending, forcing them to set aside an extra 11.4 billion pounds. This could be increased in November, the Bank said.
“Consumer credit has been growing much faster than household incomes,” the BoE said, adding that there were “pockets of risks that warrant vigilance.”
The consumer also figures prominently in the sudden shift of sentiment on the Bank’s Monetary Policy Committee that has made an interest rate hike more likely than at any time in a decade.
Annual inflation is 2.9 percent, well above the Bank’s 2 percent target and unnerving a growing number of policymakers that it could spiral out of control. Economists at Nomura even think the BoE will raise rates at its next meeting in August.
But where are these inflationary pressures coming from?
Wage growth has for years undershot the Bank’s expectations and the economy is slowing as Brexit gets underway. The Organisation for Economic Cooperation and Development reckons the UK economy will grow 1 percent next year, the lowest growth of all 32 countries in its global outlook bar one.
If the OECD is right, Britain will be the only one of these 32 countries to post slowing growth over the four years 2014-2018.
Few observers see strong domestic inflation pressures.
Although the world economy is in its rudest health for six years, global inflation is low too. The global price of oil has fallen 20 percent in the last two months to around $45 a barrel.
If oil prices stay where they are, some measures of headline U.S. and euro zone consumer price inflation will likely be below 1 percent early next year, predict economists at Citi.
Ultimately, the Bank of England’s inflation worries come down to one thing: sterling.
The narrow 5-3 vote to keep rates on hold at the last MPC meeting and chief economist Andy Haldane’s Damascene conversion last week to consider voting for higher rates show that the exchange rate is the key variable in setting policy.
Haldane estimated that the currency’s 3 percent fall since the Bank’s May Inflation Report would mechanically add around 0.2 percentage points to growth and inflation over the next two to three years.
The BoE doesn’t specifically target the exchange rate, and policymakers do their best to avoid commenting on it publicly. But while they’d never say it, the last thing they want is another wave of depreciation that will lift the cost of imports and inflation even higher.
For example, a slide to $1.20 in the coming months from $1.27 currently isn’t a far-fetched scenario. It would represent a fall of nearly 6 percent, adding a further 0.4 percentage points to inflation over the coming years, by Haldane’s metrics.
The British public’s longer-term inflation expectations for the next five to 10 years rose to 3.1 percent in June from 3.0 percent in May, Citi said last week. That’s close to February’s peak of 3.2 percent. Another sterling slide would probably result in a new high.
The Bank refrained from raising rates when inflation hit 5 percent in 2011, when the post-crisis recovery was fragile and in its infancy. Now, the global economy and banking system is in better shape, so a policy response to inflation is more likely.
The BoE’s problem is exacerbated by the yield curve. Yields are falling and the curve is its flattest since October. With stock markets rising - the FTSE 100 hit a record high this month - financial conditions are easing, not tightening.
A stable or higher exchange rate will help offset that and bring inflation back to target. So policymakers will be quietly happy that since the MPC’s 5-3 vote split on June 15, sterling has been well behaved in a fairly narrow range of $1.26-$1.28.
Reporting by Jamie McGeever; Editing by Hugh Lawson