How Not To Manage A Currency

Make no mistake, sterling’s collapse is a very serious development, and has serious consequences for sterling interest rates. While it is becoming apparent that interest rates are going to have to rise possibly for all currencies on a one-year view, sterling’s problems are the consequence of bad judgement, and perhaps intellectual arrogance on the part of the Bank of England’s Monetary Policy Committee. The MPC in turn is not and cannot be independent from the influence of Mark Carney, the Bank’s Governor, who made the expensive error of intervening in the Remain campaign.

Many commentators are saying that sterling was over-valued, and the fall will stimulate exports. But value is wholly subjective, and not formulaic, as the ivory-tower economists would have us believe. The idea of stimulating exports through lower currency rates overlooks the depressing effect of the transfer of wealth it triggers from ninety per cent plus of the population, in favour of foreigners and owners of export businesses. That is the point about stagflation.

Do not forget the bank’s stated objective, its mission statement, which is on the front page of its website. It is “Promoting the good of the people by maintaining monetary and financial stability”. Monetary stability is further defined by the Bank elsewhere as “stable prices and confidence in the currency”.  Therefore, this year it has failed spectacularly in its basic mission, as the chart below shows.

The loss of sterling’s purchasing power against other currencies since 1 January has been the least against the headline US dollar, at 17.5%. It has been marginally worse at 19% against the euro, and considerably more against the yen and gold. Unless there is a sustained recovery in sterling in the coming months, the rate of price inflation, irrespective of the outlook for economic activity, will most likely exceed 5% next year. Unilever, for example, is trying to force through price increases of 10% on its range of household and food products. The Bank will be forced to raise interest rates considerably to get price inflation back under control.

Mistakes Led To A Change In Outlook For Sterling

It’s worth considering what went wrong, so that we can better assess the future for sterling and the British economy, and to learn lessons that might apply to other currencies as well. Major central bank policies are all driven by the same macroeconomic assumptions, so sterling’s troubles may well be repeated elsewhere in due course.

At the root of the currency problem is an assumption on the part of central bankers that they have primacy over markets. This primacy has become increasingly evident since the breakdown of Gibson’s paradox in the 1975-1982 period, when interest rates no longer reflected demand for savings by business investors. They began to be set by monetary policy aimed at managing consumer demand instead. It marked an economic evolution away from commercial activity in favour of the purely financial, and as that trend gathered momentum, central banks exercised more and more control over the deployment of capital. Notably, governments were able to finance their accumulating deficits with progressively lower interest rates, taking financing costs towards the lower bound.

It is a process that cannot continue indefinitely, because, as the old adage goes, markets eventually reassert themselves. This adage is a summation of all that’s wrong with monetary and financial collectivism, the inability of central planning to allocate capital resources as efficiently as free markets. Sooner or later, a mistake, changing circumstances, or a black swan event leads to a financial or currency crisis. This happens from time to time, and every time the lenders of last resort manage to save their carefully constructed artifices, they say there are lessons learned, and it won’t happen again. Hubris.

Mark Carney made a definite mistake. It was exacerbated by a change of circumstance, but was not a black swan event. As one of the world’s most respected central bankers, Carney apparently believed he had the authority to frighten the British voter into rejecting Brexit by threatening an economic apocalypse. His public utterances ahead of the vote ensured sterling would crash, and financial markets with it, when the vote went Brexit’s way. That event in June is clearly reflected in the chart above. Having dug himself into a hole of his own making, Carney then dug even deeper. Despite all the evidence to the contrary, he continued to believe his own propaganda, that the consequences of Brexit would be dire on a medium-term view. Without waiting for confirmation, the BoE cut interest rates and announced a further round of bond purchases.

Sterling is taking it on the chin. Such is the groupthink in the Bank and in the City that there was no one credible with the sense to advise caution. Large financial corporations are still lobbying furiously for a quasi-remain solution to Brexit, with continuing access to Europe’s broken financial system. Ergo, if they are threatening to move to Frankfurt, Paris and now even New York, the outlook for Britain must be bleak.

Doubtless, Carney and Co. will continue to blame Brexit for sterling’s accelerating collapse, as well as rogue traders (viz. the flash crash last week). The problem with hubris is the blame always lies elsewhere.

The Prime Minister and her Chancellor have also been unhelpful. At the Conservative Party conference greater economic intervention was promised, and the Prime Minister herself stepped over the boundary of the Bank’s independence by criticising QE. The Chancellor’s remarks, perhaps reflecting the opinions of his officials, were similarly unhelpful for sterling, and it has since emerged that Treasury civil servants are trying to subvert Brexit, fearing loss of tax revenue.

Investors and traders now have to contend with a sharply different market environment. Referring back to the introductory chart, it is clear the best performing money for hapless Brits has been gold. Gold has risen this year, priced in all the major fiat currencies, which tells us that commodity inputs to price inflation around the world are turning positive. This is confirmed by the following chart, based on the St Louis Fed’s Producer Price Index for All Commodities, adjusted by the sterling exchange rate, and indexed to October 2011. The implied inflation rate, smoothed over four quarters, is the red line plotted on the right hand scale.

Wholesale price inflation on this measure bottomed strongly negative in the middle of 2015, but since then has become strongly positive. This is partly due to the dollar PPI rising by 20% from January this year, but the rest is due to sterling’s weakness.

The root of everything we buy is the commodities and raw materials in this index. When we buy services, we pay service-providers who in turn will spend some of the money on goods, and their service providers in turn will equally spend a portion on goods. Therefore, producer prices are fundamental to all economies, including one like the UK, in which an estimated 80% of GDP is represented by the service sector. To see PPI inflation running at 25% after -25% is therefore an extremely serious issue.

Consensus forecasts for UK price inflation do not appear to take this sufficiently into account. The Bank of England in its August Inflation Report expected price inflation to be only 2% in three years’ time, though independent forecasters have expected it to be somewhat higher, perhaps 2 ½ per cent by the end of next year. However, the fall in sterling is forcing analysts to revise inflation forecasts upwards, with Deutsche Bank saying “higher import prices should add nearly four per cent to CPI over three years…. However, if sterling bears predicting a further 10% decline prove correct, inflation’s 25-year high of 5.2 per cent may be threatened” (Fast FT, July 11^th).

Since that report, sterling fell by a further 10% in last week’s flash crash, though it has recovered somewhat. There is no doubt that the UK’s price inflation in 2017 is the one subject analysts will be waking up to in the coming weeks. But it’s not just the fall in sterling that will push the Consumer Price Index significantly higher, but commodity prices as well.

One thing’s for sure, a swing in sterling PPI inflation from -25% to +25% in only fifteen months will have a major, and generally underestimated effect on headline price inflation. The Bank of England’s published forecast is a make-believe, and it is frightening that the MPC thought inflation would remain under its 2% target to the point where it felt a cut in its Minimum Lending Rate was warranted. With the bank going one way on interest rates and reality the other, the only way to prevent further devaluation is for the Bank to jack up interest rates as soon as possible before further damage is done.

The Seeds Of Stagflation

The BoE raising rates immediately is extremely unlikely, so we face the unwanted prospect of stagflation. The BoE’s monetary policy will be torn between two contrasting objectives, a stagnating economy and escalating price inflation. The economists at the Bank will want to keep interest rates down to encourage growth, while markets will demand higher interest rates all along the yield curve, forcing up the cost of borrowing for government, corporations and consumers. If we repeat the experience of the seventies, which we seem fated to do, both the Treasury and the Bank will persist in the view that markets are wrong, and they are right. They will tough it out until a good old fashioned sterling crisis changes their minds.

The Bank’s mistakes in monetary policy will have far-reaching implications. The level of mortgage debt in the UK is at record levels, so residential property prices are likely to take a very bad hit from significantly higher interest rates. The inability of many businesses to pass on higher input prices to cash-strapped consumers will lead to a downturn in economic activity, falling profits and wages in real terms, and increased unemployment. Savings, which have been progressively channelled out of bank deposits and into speculative capital assets, will suffer losses. Because levels of debt today are far higher than they were in the last stagflation episode in the 1970s, the fall-out from Carney’s mistake threatens to be considerably greater today.

Commodity outlook rubs salt in the wounds

As if the pound’s problems were not enough, the medium-term outlook for commodities is also for rising dollar-denominated prices. The reason this is so is that the Chinese economy, which the IMF and western economists routinely criticise, is being deliberately refocused away from low-value production towards higher technology products and a massive infrastructure programme covering much of Asia. The current resurgence of the dollar, which is behind commodity price softness in the last two weeks, is therefore likely to prove temporary. That being the case, it is clear that the US economy also faces stagflation, if only on a lower scale than the UK.

It is for this reason that a rise in dollar interest rates also seems inevitable. In fact, wholesale markets are already pricing dollar credit well above the Fed Fund Rate, indicating prima facie that the FFR should be 0.5% higher. This trend of higher wholesale interest rates has been in place for some time as the next chart clearly shows.

Furthermore, when the Fed raises its Fed Funds Rate, it is more than likely the interbank rate will rise above it, encouraging the Fed into a game of interest rate leapfrog, because the 12-month LIBOR rate is already at 1.58%. So we can conclude that the Fed is well behind the interest rate curve already, reflecting the classic stagflation dilemma. The imperative to resist raising interest rates before the economy faces capacity constraints contrasts with the growing need to raise interest rates to curb price inflation. The Fed is currently choosing to ignore the inflation outlook.

This being the case, it appears that the Fed in a milder way is caught in the same trap as the BoE. It will only raise interest rates significantly as a last resort, when forced to do so by the markets. The idea that markets, after all, will disrupt their monetary plans, have always been extremely unwelcome and strongly resisted by central bankers everywhere.

Rising dollar interest rates will also provide a severe test for the ECB’s monetary policies, and threaten the Eurozone’s banking system, but the path to the euro’s loss of purchasing power has bigger factors at play than simple stagflation. The Bank of Japan faces other difficulties, and stagflation is not an immediate concern there. It is the two Anglo-Saxon currencies, whose issuers believe in both free markets and state management at the same time, where the dangers of stagflation are most odious.

Free markets and state management are like oil and water, and simply don’t mix. State management of both interest rates and the quantity of money and credit dupes the general public for a while, but not for ever. And when the ordinary person wakes up to the decline in the purchasing power of his money he reduces his cash liquidity in preference to ownership of consumable goods. No matter that higher interest rates bankrupt the over-indebted. No matter that rising unemployment leads to a general sense of job insecurity. No matter that the majority of people have little or no cash liquidity. Those that do have cash and start to accumulate the necessities of life may be a growing minority, but they are sufficient in number to drive up retail prices by creating inventory shortages. They are only the first to realise that raw material and other processing costs are rising, and that the purchasing power of their money is falling.

This realisation spreads, which is why stagflation leads to hyperinflation, unless it’s halted. Stopping it means forgetting monetary policy objectives, and either letting the market determine rates, in which case the ability of banks to create credit out of thin air has to be curtailed perhaps by the threat to their own insolvency, or rates are deliberately raised by the central bank high enough to crash the economy.

It was the market that forced a reluctant BoE to accept reality in 1975, principally through bankruptcies in the commercial property market (which is where the leverage was at that time) and in their lenders, the secondary banks. By way of contrast, the Fed, chaired by Paul Volcker, took the initiative over markets in 1981, jacking up interest rates until the economy stalled and people preferred money again to spending it. This time around, US government debt to GDP is over 100%, in 1980 it was about 30%. In the UK, most houses were mortgage-free in the 1970s. Today 80+% mortgages are typical. The consequences of markets regaining control over interest rates are considerably more dangerous today. Volcker’s interest rate policy was practical twenty-five years ago, in that the fall-out was generally containable. We cannot say that is true now, with all the debt that would default.

This has always been the basic argument for not putting trust in fiat currencies, instead having a form of money whose purchasing power is more stable in terms of commodities and raw materials. The Bank of England’s inept monetary policies under Mark Carney’s governorship seem certain to expose the fragility of fiat sterling to wider public attention and scepticism. If the consequences weren’t so serious, we might thank him for unwittingly toppling the status quo. But the inevitable crisis, many times worse than that faced in 1975, cannot be embraced even by the most extreme financial masochist. This is why people in Britain and America will increasingly find solace in gold.

Alasdair Macleod

HEAD OF RESEARCH• GOLDMONEY

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