Bill Jamieson: Pounding of sterling risks a currency war

But Bank of England Governor Sir Mervyn King’s upbeat summary last week had another darker and worrying message.

First there was the now-routine admission that the Bank’s previous inflation forecasts had proved over-optimistic. Then came the prediction that, far from falling back towards the 2 per cent target this autumn as he had previously signalled, inflation is set to rise to 3 per cent and more, and remain above target for the next two years.

Inflation has now been running above target for 38 months in a row. The Governor has told us this overshoot will persist for another 24, taking the run of policy failure to 68 months – and with no hint of policy action to bring inflation back towards the official 2 per cent level.

So much for this being some “temporary overshoot”. Long before then, savers, investors, holders of sterling and, most critical of all, purchasers of UK official debt will have cause to doubt whether the UK has any real intention of holding down inflation to the stated target. Even the attempt to hold down inflation expectations looks to have been abandoned.

Once this assumption settles in, the sterling exchange rate becomes vulnerable. Confidence in sterling is already brittle, given the state of the UK’s public finances and its stagnant economy.

Combine this warning of persisting inflation with a fading resort to quantitative easing, or printing money, opening the spectre of currency devaluation, and who would be confident about holding sterling assets against such a backcloth? Indeed, the implications did not take long to sink in. Last week the pound slid against the euro and the US dollar.

A weak – or weakening – exchange rate has tended to be seen as a boon when the economy is on the ropes. It works to make our exports relatively cheaper in world markets, boosting order books, output and employment.

This, however, could never be the formal stated aim of policy. It would be denounced as beggar-thy-neighbour currency devaluation. Now comes the danger of straightforward currency manipulation, triggering a currency devaluation war, with the most damaging consequences for world trade and growth.

The hope is that governments and central banks will step back and prevent the advanced economies from being locked into monetary mayhem. But with data last week from the Eurozone showing a bigger than expected fall into recession, President Obama anxious to stimulate a recovery in the US, and Japan set on a policy of stimulus and yen depreciation, an early step back from this brink cannot be counted on.

And at the household level here in the UK, a weakening currency is bad news. It drives up the cost of raw materials and imported goods. This feeds through the production chain into higher prices in the shops.

With household incomes already lagging the pace of inflation, it threatens a further shrinkage in real household spending power. We will feel, and be, poorer.

Now consider the implications for government debt. Investors’ best guess at inflation over the next decade is close to its highest level since the onset of the financial crisis. Anyone buying UK government gilts would demand an interest rate or yield that would at least provide compensation for the fall in value resulting from inflation.

The ten-year gilt yield is now around 2.2 per cent, having appeared to bottom out last August.

The Bank is loath to raise official interest rates – currently at an ultra-low 0.5 per cent – as the economy is still highly fragile, and higher rates would bring a storm of protest. Gilt-edged investors would therefore be tempted to sell off, forcing yields up, before buying any more debt.

But the UK government is reckoned to need to borrow another £440 billion by issuing gilts between now and April 2017. Who’s going to buy that £440bn, especially if the Bank’s latest inflation forecast proves to be as over-optimistic as previous efforts? A gilt “strike” could well be the consequence, sending the worst possible signal.

The one bizarre silver lining to this cloud is that other major economies are in little better condition. In the US, output has been running well below its trend rate of growth. In Japan, GDP fell by 0.1 per cent in the fourth quarter.

Europe has fared worse. France is reckoned to have contracted by 0.3 per cent (similar to the UK) while Germany’s GDP dropped by 0.6 per cent and Italy’s by no less than 0.9 per cent. On an annual basis, Germany recorded just 0.4 per cent growth and Japan 0.1 per cent. France’s GDP actually declined by 0.3 per cent, while Italy’s collapsed by 2.7 per cent. Looking at data from France and the Netherlands, it is looking ominously as if distress on the periphery is spreading to the core.

Why should this be? Economist Charles Dumas at Lombard Street Research argues that the fall in fourth-quarter GDP across the four major economies of the Eurozone highlights their lack of structural adjustment. “Whatever emergency stimulus, fiscal and monetary, was adopted in late 2008 and subsequently, it is now four years later,” he writes, “ and there is no excuse for using such ‘crutches’ to postpone structural adjustment yet again.

“Poor Eurozone growth for the past ten years suggests the crisis was not just a matter of certain countries behaving badly. In Germany and Holland too, growth has been entirely inadequate, well below the US and UK, let alone natural non-Eurozone comparators such as Sweden and Switzerland.”

The same, of course, could be said about the UK and its reliance on QE and fiscal stimulus to do the work of structural reform. It has never worked in the past, and will not do so now.

As for the policy stance of the G20, it was adamant in the wake of the 2008 crisis that countries should at all costs avoid competitive exchange rate moves and trade protection that had added to the 1930s depression. But a politic silence has since reigned over the resort to QE, and the threat of currency wars is now much nearer.

We have sailed deep into dangerous waters. Sir Mervyn King’s admonition last week that this would not be a normal recovery should not just be taken as read. It is already well on the way to being the central banker understatement of the year.

Twitter: @Bill_Jamieson