[EUR] FX Alert: Still no policy credibility left increasing risks to GBP

FX Alert: Still no policy credibility left increasing risks to GBP

A couple of months ago we wrote in an FX Alert entitled 'No policy credibility left in the UK' that both monetary policy and fiscal policy were likely to loose credibility and prove GBP negative. The evidence is mounting even faster than we had anticipated on all fronts and in our favour (i.e. GBP negative). More importantly this view is increasingly being reflected in the wider financial press. In yesterday's FX Comment we cited the widely reported reasons on how the newly established Office for Budget Responsibility had essentially lost all credibility for independence (in record time). It was supposed to bring some credibility to the UK government's growth and debt projections. But as the FT newspaper pointed out last Friday, the OBR's assumptions on trend growth, public/private sector jobs growth and implications of the Emergency Budget on UK growth prospects conveniently clearly favoured the current coalition government's policy judgements (i.e. faster pace of fiscal consolidation was needed).

Today Bloomberg carries an opinion piece on by ex-BoE MPC member David Blachflower which does an equally damning hatchet job on the MPC and Boe Gov. King. Essentially he argues that the BoE forecasts are made by BoE Gov. Mervyn King and are essentially doctored to suit his bias ('you can just make stuff up as you go along'). Blanchflower notes how King can dismiss the forecasting team that put together the BoE CPI/growth forecasts if they do not come up with a set of numbers that he agrees with his views. This is important because currently King appears increasingly isolated on the Committee. The latest inflation figures are a perfect illustration of how he is loosing the argument. He has argued that there is no inflation problem in the UK and that this is a temporary blip up due to a variety of factors such as depreciation in the exchange rate, oil prices, VAT etc.. Last year King forecast that inflation in the fist half of this year would be around 0.8%y/y, instead of the above 3%y/y figure we have seen. This has been one of the biggest forecasting errors the MPC have made. However there is a growing rebellion within the Committee. Several MPC members have over the past year noted the 'stickiness of UK inflation'. It started off with ex-BoE Chief Economist (and current Deputy Governor) Charlie Bean noting the upside surprises in UK CPI last year. More recently Bean's concerns have been echoed in the comments of current BoE Chief Economist Spencer Dale. Finally Andrew Sentence, after a period of voicing concerns over inflation has finally broken cover and actually started to vote for higher rates. Adam Posen is another member who has noted the worrying trends in UK CPI and explicitly said they cannot be attributed to one off impacts. Hence at least four members do not share King's view.

Hence the next forecasting round (ahead of the Aug Inflation Report) is likely to be particularly difficult if King tries to keep the MPC Committee to the view that UK inflation is 'under control'. Today's CPI figures are more worrying because they showed core inflation tracking higher to 3.1% y/y (back to a record high). This element is supposed to exclude the temporary one off factors that King says is responsible for the higher inflation outturns. To put King's argument in perspective, it is very surprising that after one of the deepest recessions the UK economy has experienced (-6.2%y/y fall in output last year) that inflation (especially core CPI) is still so far above target. Usually inflation tends to reflect the output gap with a lag of about a year. Hence last year's fall in output should have seen UK CPI crater this year. Yet the FX markets still seem to view the MPC as being credible inflation fighters. When inflation comes out robust then GBP rises because they expect interest rates to be hiked up. But there must come a point when BoE looses credibility and a higher inflation outturn actually sees GBP decline. Moreover the emerging divisions within the monetary policy cannot be good for GBP either.

If monetary policy looks divided and lacking credibility the same is likely to be true of fiscal policy. We show below the correlation between the y/y changes in Cable (GBPUSD) and the UK monthly budget deficit. Clearly it appears that the market is already expecting the deficit to start to worsen. Hence the market appears to have lost a lot more faith in fiscal policy than monetary policy.



More worryingly current MPC member Adam Posen, while noting the upside risks to inflation also highlighted the risks of a double dip in growth in the UK later this year. His comments are particularly important because he is on the MPC as a Japan 'double-dip' expert. Hence he knows the policy mistakes that caused the double dip in Japan in the mid late 1990s and resulted in two decades of stagnation. Moreover given the dogmatic approach to forecasts that currently reign at the BoE it is more plausible that King, driven by concerns over fiscal policy, could have been more optimistic about the prospects for growth under the austere government budget. So comments by Posen will need to be watched closely in the months ahead. Worsening growth prospects are likely to put strains on the new coalition government. Here the latest GDP figures gives even more cause for concern and go against King's view of private sector or export led recovery taking the place of government. The latest revisions to GDP show that UK growth was more dependent on government spending. Moreover the contributions from net exports have been revised down, from flat in the last quarter to a negative contribution of around -1.7%q/q. As such another pillar of Gov King's growth projections, the rebalancing of the UK economy towards more export led growth is looking less credible.

S&P also recently reaffirmed their negative outlook on the UK economy citing growth concerns. They also stated that growth would be weaker than that projected by the newly created OBR. This follows on the back of the latest IMF growth forecasts that showed an upward revision to growth of all the advanced economies except for the UK. The latest growth indicator have also led to more opinion pieces by noted commentators such as Martin Wolf of the FT which note the growing downside risks to growth. Finally the upcoming forecasts by the BoE in the August Inflation Report will also lack credibility given King has already stated his bias. It may be more interesting to note what risks the MPC cite around its central growth forecasts. This is usually how dissenters can express their views.

So as growth slows it should put further strains on the new coalition government. This is because only one of the coalition parties actually favoured a faster pace of fiscal consolidation. As a result risks are growing that the UK is headed for a period of division on both monetary and fiscal policy. This is likely to be very GBP negative and will further undermine the credibility of both monetary and fiscal policy further.
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