The pound rose sharply last Wednesday on speculation that the Bank of England will soon raise UK interest rates. The nine-strong Monetary Policy Committee was “unanimous in its decision” to keep rates at 0.5pc, the newly published minutes of its July meeting showed.
That was as expected. The UK’s “bank rate” has been on hold, after all, for no less than 76 consecutive months. “A number of members”, though, are now considering an increase, the latest minutes revealed. And that was what moved the needle, with the pound up over half a cent against the euro the day the minutes were published.
For months, market expectations have pointed to a rate increase in mid- or late-2016. In recent weeks, though, there have been widespread predictions the balance of opinion on the MPC will swing towards a rise much sooner. One reason is that the UK economy, having grown no less than 2.9pc during the first quarter, is now officially expected to chalk-up a buoyant 2.5pc expansion during 2015. Bank of England governor Mark Carney has fuelled the rate-rise speculation, suggesting we could see an upward movement as early as “the turn of the year”.
The MPC’s latest minutes go further, reporting that the committee now thinks inflation, which fell back to 0pc in June, is anyway “likely to pick up notably” towards the end of 2015. Were it not for the “unusually low” contributions to the inflation rate from energy, food and imports, the minutes noted, inflation would already be around 1.5pc – approaching the 2pc targeting.
We’ve recently learnt the UK saw wage growth of 3.2pc during the three months to May – the fastest rise in pay since April 2010. The MPC is also mindful that the sharp drop in oil prices over the last year will soon drop out of the annual numbers, again causing the headline inflation rate to rise.
At previous MPC meetings, the decision to keep rates on hold has been “finely balanced” for two committee members. The latest minutes, though, suggest “a number of members” are now close to voting for a rise. That’s been interpreted to mean that three or four rate-setters could opt for an increase as soon as the August or September MPC meetings – perilously close to the five-vote balance-tipping majority.
For those “finely balanced”, the situation in Greece has been “a very material factor in their decisions”, said the minutes. In other words, concerns about Grexit, and related turmoil on financial markets, have so far convinced them it’s too early to raise rates. But now fresh emergency finance has been extended, and the danger of Grexit has passed, the chances of an early rate increase – in both the UK and America – are stronger.
That’s the official narrative. As I wrote last week, I don’t buy it. For one thing, the possibility of Grexit is in no way behind us, and sits alongside several other systemic dangers – not least an extremely precarious Chinese stock market. The economies of both the UK and America, meanwhile, their upturns mainly consumption-driven and debt-fuelled, remain rather weak. It’s that combination of on-going systemic danger and economic fragility that leads me to conclude both the Bank of England and America’s Federal Reserve remain quite a long way from raising rates.
On the currency markets, though, the pound reflects the growing sense that UK rates will soon rise. Carney’s recent verbal intervention sent sterling above 1.44 to the euro, a seven-year high. Over the last year, as the prospects of a British rate increase have risen, and the eurozone has launched fully-blown quantitative easing, hosing down its addled bond markets with virtually printed money, the pound has risen by over 11pc against the single currency.
That is worrying. The Eurozone is the UK’s biggest trading partner by far – accounting for half our overseas commerce. An 11pc currency shift will have seriously dented or even wiped-out the entire profit margin of many British exporters. While hindering our manufacturers, a stronger currency, by making imports cheaper, also result in an even greater share of UK growth being reliant on consumption.
Such concerns aren’t lost on the MPC. Sterling has “appreciated markedly” over the previous twelve months, reported the minutes, while noting that the “appreciation of the exchange rate could have an adverse impact on the balance of growth in the economy”.
Despite that, the markets remain fixated on the notion that either the UK or America will be the first major central bank to raise interest rates, which keeps both sterling and the dollar strong against the euro. With the European Central Bank and Bank of Japan in the throes of QE and the Bank of China on emergency alert given the dangers of a domestic equity meltdown, that would seem to make sense – even if I’m right and the Anglo-Saxon banks do indeed take longer than is widely expected to make their first move.
In the meantime, a rising pound – by encouraging imports and undermining the sale of UK goods and services abroad – will continue to damage an already extremely weak UK external balance. While it’s unfashionable to talk about the current account these days, now that sterling is no longer a fixed exchange rate, I make absolutely no apology for pointing out that the UK is currently sporting a huge balance of payments shortfall.
In 2012, the external deficit was 3.5pc of national income. Then it grew to 4.7pc. Last year, the UK’s current account deficit was no less than 5.9pc of GDP – the worst performance on record. As the Eurozone has tanked, a weaker euro and stronger pound have pulled apart our exports and imports. This year, as long as the rate-rise speculation continues and sterling keeps rising against the euro, our external deficit could get even worse.
For many years, the UK has run a deficit on visible trade – like goods and raw materials. This won’t be reversed any time soon, seeing as our last surplus on manufactured goods was in the early 1990s and we’re now a net oil importer.
In recent decades, our deficit on “visibles” has been offset, and some years more than offset, by a surplus on both services (in particular financial services), plus investment income from abroad. Now, though, while our service surplus remains, our investments are deeply in deficit – in part because the government is paying large sums to holders of UK sovereign debt based abroad.
For now, while Britain is projecting an image of strong growth and the Eurozone is a mess, sterling is seen as a safe haven. Our government talks a lot about “austerity” – and rather less about our massive external deficit or that our budget deficit remains close to 5pc of GDP. So the pound is strong – and getting stronger, of course, given speculation that UK rates will soon rise.
In the end, though, and no-one can tell when, the market’s attention will shift, and it will become apparent that the UK, in fact, has a huge double deficit. That would result in the pound dropping fast, causing imports price and inflation to spike and forcing the Bank of England to take nasty emergency action.
I’m not saying this scenario will play out – and I sincerely hope it doesn’t. But the longer we wait before raising rates, and the more the pound spiral upward, the higher the risk of a balance of payments emergency, a resulting currency collapse and a series of aggressive rate rises.