The Bank vs. Bernanke


If the Federal Reserve continues to lower interest rates, it is possible that a new carry trade may emerge: borrow Treasuries to buy Sterling.

I know that seems far-fetched, but the Bank of England’s interest rate stands at 5.5% - already a 2% spread. The text of the speech that Governor Mervyn King gave in Bristol, England last night is quite interesting. Countering Bernanke’s beliefs without mentioning the Fed, King said that “The re-pricing of risk that is still continuing is not a process that we should try to reverse.”

King elaborates: “Although central banks can and will respond to the consequences of strains in the banking system for their economies, the solution to the underlying problem does not rest with them but with the banks and financial markets themselves. Banks must reveal losses promptly, and most importantly, raise new capital where necessary."
This is the clear philosophical difference between the BoE and the Fed. The Governor is telling banks and the markets that they made their bed and now they must lie in it. It’s not the BoE’s job to prop up the London Stock Exchange.

And here’s the kicker. King believes “The adjustment which not only the British but the world economy is experiencing is necessary as the imbalances, between spending and saving and between domestic demand and trade, unwind. As part of a longer-run rebalancing of the UK economy, an increase in our national saving rate, both private and public, is necessary. Unless we spend less and save more, our current account position will deteriorate.” (Italics mine.)

I guess American Express (AXP) doesn’t air their “The more we spend, the more we save” commercial in the UK. To the Fed, Wall Street, and the U.S. government, such beliefs are sacrilegious. Here the idea is to keep the consumer in debt up to their eyeballs so they’re slaves to the government to do whatever they want with them in the name of “national security”. Low rates encourage those who do have cash, along with local government and pension funds, into risky investments to obtain even reasonable yield.

Unlike the Fed, King is clearly concerned about inflation’s adverse effects worldwide:
“Inflation has picked up in the industrialised world. It is now 3.1% in the euro area and 4.1% in the United States. (Bold emphasis mine.) And although consumer price inflation here is close to target at 2.1%, three developments now threaten to push it significantly above target this year. First, oil prices are around $90 a barrel, although they have fallen back in recent days. In August, the price was $70. Second, oil price increases have been accompanied by rising gas prices in wholesale markets. And this month we have seen announcements from suppliers of increases in household gas and electricity bills of the order of 15%. Third, world food prices have risen sharply as a result of strong demand growth on the one hand and poor harvests from South Australia to North Carolina on the other. Food prices on world markets are a third higher than they were six months ago, and that has been feeding through to prices in the shops. Food price inflation in our own Consumer Price Index reached almost 6% in December."

"So 2008 is likely to see higher energy prices, higher food prices and, with a lower exchange rate, higher import prices, pushing inflation above the 2% target. It is possible that inflation could rise to the level at which I would need to write an open letter of explanation, possibly more than one, to the Chancellor. Although there is little we can do now to avoid some rise in inflation this year, the task of the Monetary Policy Committee is to ensure that it is short-lived. (Italicized emphasis mine.) If inflation expectations were to pick up in the wake of a rise in inflation this year, then only a more prolonged slowdown would allow inflation to return to target. But if the rise in inflation does not affect longer-term expectations, then
inflation could start to fall back towards the end of the year.” The Bank’s bottom line is that “We are determined to keep inflation on track to meet the 2% target in the medium term.”

King concluded his speech by basically saying that the volatility in the markets has to play out. Unlike the Federal Reserve, it appears that the Bank of England knows their role:

“Although we have little control over the strength of the economic winds buffeting our economy, our framework of inflation targeting does, as I said in my first speech as Governor almost five years ago, provide a seaworthy vessel. We cannot avoid some volatility in the short run and it is important that everyone understands the limits to the ability of central banks to smooth the economy. But, by keeping our eye firmly on the need to keep inflation close to target in the medium term, we can reach the calmer waters of low inflation, steady growth and a better balanced economy. And our policy framework will, I hope, allow you not to be overwhelmed by the headlines and to focus on what really matters for our future prosperity – the successful running of your own businesses.”

1 comment:

eh said...

Interesting rhetoric from King. But I wonder: Does his (seemingly) principled stance stand a chance facing the kind of market blackmail we just saw used against the Fed? Give us a big rate cut or the market will drop 1000 points. And don't wait until the next FOMC meeting to do it.

I think we can expect to see rate cuts coming from the BOE and the ECB in the near future. European exporters will demand it.