One of the key indicators we monitor in order to gain an insight into the UK economy here at DGC Asset Management is the Bank of England's quarterly Inflation Report, which often gives us a perspective on the prospects of the British pound, as well as potential trends developing in the economy in general. This quarters’ report, published on May 16th, contained some interesting points that we had not noticed in previous reports.
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Bank of England Inflation report - May 2012
There was of course plenty of commentary of the need to rebalance the British economy, and great urgency was assigned to this in light of the on-going crisis in the Eurozone, and the general feeling of the report was that the British pound had little fundamental support in order to achieve and sustain a real appreciation or ‘safe haven’ status amongst investors.
For the first time – that we can remember – BoE officials were open in noting that the rise in inflation had surprised them due to the fact that the historical trends on which they had based their actions had not repeated themselves as they had hoped. With the benefit of hindsight, they admitted that the actions they took in order to try and halt and reverse a total economic collapse were based on experiences of the 1990s when an appreciating currency did not in fact lead to substantially higher inflation. Instead, it seems that the current situation is more akin to what happened in the 1970s and 80s.
Whilst the 25 per cent depreciation in the value of GBP Sterling was highlighted as partly responsible for increasing inflation numbers, higher oil and commodity prices were also fingered with the blame, along with an increase in VAT. And whilst wages remained suppressed, offering some counter-inflationary pressure, the main source of inflationary relief said to be on the way was the fact that futures prices for fuel indicate prices may fall, offering consumers some respite in spiralling living expenses. It should be noted that reporters in the audience sounded somewhat sceptical of this promised inflationary relief – with an air of ‘we’ve heard that before’.
As the BoE sees manufacturing and export as a key driver of economic recovery, the deprecating pound is viewed as a necessary evil in order to rebalance the economy, believing that the benefits of depreciation remain intact for the United Kingdom, and the overall plan includes a gradual tightening of fiscal policy and loose monetary policy (low interest rates and quantitative easing through asset purchases). The BoE also proudly declared that few countries are facing up to these challenges as the UK is doing. For example, Germany and the Netherlands have yet to face up to their own need for rebalancing.
As far as Europe is concerned, the BoE holds out little hope for any dramatic positivity coming out of the region, and admitted that the Eurozone crisis makes the rebalancing of the UK economy more challenging. We suggest that the UK’s own economic prospects are inherently reflective of this, and are likely to remain subdued. The Inflation Report includes the following commentary on this subject: The prospects for UK growth remain unusually uncertain. The single biggest threat to the recovery stems from the challenges within the euro area, in particular the need to reduce the indebtedness and improve the competitiveness of some member countries. A failure to implement such policies could have severe implications for the UK economy.
Direct translation: The pound probably won’t appreciate much in the short term, other than potentially over the Euro. Previous talk of GBP being seen as a safe-haven were quashed in May as the pound plummeted against the US Dollar and Japanese Yen, and Christine Lagarde, Managing Director of the IMF thinks the UK economy remains at risk, stating that the BoE should move forward with further quantitative easing (QE). More QE should of course place even more pressure on the currency - unless the current plunge is all about pricing in an imminent increase in QE.
Governor Mervyn King took the opportunity to once again espouse the woes of the Eurozone when answering a question, stating:
What is so depressing about it is that this is a re-run of the debates we had about the banking sector in 2007/08. These are not liquidity problems; they are solvency problems. These are big - the imbalances between countries in the euro area have created creditors and debtors, and at some point the credit losses will need to be recognised and absorbed and shared around. And until that is done, there will not be a resolution of the problem. And that is why just kicking the can down the road is not an answer. The European Central Bank has performed heroically in trying to buy time, but that time hasn't been used to put in place underlying fundamental solutions.
King made a note of saying that it is not the survival of the Euro which is the key issue, but rather the need for a rebalancing of competitiveness, external deficits, and trade surpluses in Europe, a rebalancing which must include the recognition of credit losses, and despite two years of ‘debate’ no solid course of action has yet been set.
Another key point of interest is spare capacity, a relatively reliable indicator of economic performance. When production capacity is fully utilised, we see economic growth as prices increase along with demand for labour and resources. Higher wages lead to increased demand for goods and services and a positive cycle of growth forms. When production remains below capacity this cycle tends to work in reverse – unemployment increases, wages decrease and demand drops off – leading ultimately to economic stagnation or contraction.
Spare capacity is the difference between what an economy could produce, and what it actually produces. The BoE stated during this report that it could not in fact effectively measure the gap in production, but different surveys have delivered widely ranging estimates on spare capacity, and the BoE thinks that it could be 10 to 20 years before production returns to pre-recession capacity and utilisation levels. Furthermore, the Central Bank does not expect that it will be able to manipulate production in the next 2 to 3 years.
Finally, and perhaps most interesting, was the discussion on uncertainty and risks, with the BoE once again attempting to make it quite clear that any forecasts issued by the bank were inherently fraught with uncertainty, and Mervyn King offered a deeper than usual explanation for those interesting in interpreting the data and measuring the quality of decisions:
Forecasting is not about producing a number. It's not a spot the ball contest where you say 2.7 or 3.2. The most that you can hope to do - and we've been very open about this for 20 years - the most that you can hope to do is to assess the balance of risks. Inevitably, if you take a forecast as a point forecast, with probability almost one, it will turn out to be wrong. The question is - what do you see in the data and does that change your view about the balance of risks looking forward?
So I think the question of whether you should take what we say seriously has to depend not on looking at precise numbers or even at the fan charts, but on - do you think the explanations we give for why inflation has moved as it has are plausible explanations? And do you think that the inferences we draw from those explanations about the balance of risks to the future are reasonable?
If you do, then I think you would say - yes, of course, no one can know the future, but these are reasonable judgements. If you disagree with our interpretation about the economic analysis, then you would probably take issue with the judgments we make about the future. But I think what's most important is that whatever debate is had is not in the context of right or wrong, it's in the context - were the explanations reasonable and did they lead to reasonable judgments about the future?
This didn’t go down well at all with reporters keen to have a peg on which to hang the blame for bad decisions. Interestingly, the BoE warned the audience that it should not think about risk in the same way it did before the onset of the financial crisis, and that it makes little sense to assume risks are easily calculable in terms of quantitative probabilities.
In summary, it does not seem to make a great deal of sense to try and predict the likely direction of the British pound, but it will be interesting to see whether the currency will find enough buyers in order to reverse the current downward trend against the US Dollar and Japanese Yen, or whether in fact the current uncertainty hanging over the UK and Europe will continue to quash its value. In our opinion, there is such poor visibility in the global economy in general that any currency movement will be born of the latest short term economic event, as the long term fundamentals remain unclear at best. Until we see a solid action plan in Europe, we think that the current weakness is likely to continue.
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