The Price of a Sterling Crisis
March 15th, 2009Via: Guardian:
In order to know whether sterling’s decline is cause for worry or cheer, we need to examine its causes. Research commissioned by the Monetary Policy Forum suggests sterling may have moved to a permanently lower level, reflecting a preference shift away from what the UK was thought to do best: financial services. We attribute about 30% of sterling’s decline to this factor. The drop in UK rates to levels not seen for 300 years has also played a part, explaining about 10% of the move. But our results suggest roughly 60% of the explanation lies in a higher risk premium.
Put plainly, the UK and its currency are now perceived as a riskier bet. Sterling’s decline may be telling us that overseas investors see a significant risk of inflation ahead. It’s not hard to see why. It took the Bank of England far too long to appreciate the potential damage the build-up of household debt and the associated bubble in house prices might cause. The ensuing crisis has forced the banking system into the government’s arms, pushing up net government debt, which Brown pledged to keep always below 40% of GDP, to well over 100%. History teaches us that governments deep in debt are more likely to tolerate higher inflation. And this week the Bank of England began creating money in order to buy some of this outstanding debt – in effect monetising the deficit.
And yet, according to the latest forecast from Threadneedle Street, there is almost no chance of inflation breaching its 2% target before the end of 2012. In our view, this is not credible. We believe the UK authorities are downplaying the risk of high and volatile medium-term inflation. And that in itself further underlines the risk to investors of holding sterling. If that perception is allowed to become a self-fulfilling prophecy, Britain will be the poorer for it.
