UK Edition
Be grateful for the strong pound. If it were not for the soaring global exchange rate of sterling, the inflation shock this winter would be even more extreme.
The 7.5pc rise in the retail price index is the highest since the peak of the Lawson credit boom over thirty years ago. The difference today is that the UK is not trying to shadow the Deutsche Mark within the pre-euro Exchange Rate Mechanism.
This country can let the currency rise to help break the back of inflation, and the Bank of England can conduct an autonomous monetary squeeze, assuming it has the nerve to do so.
Both forms of macro-economic tightening cause serious collateral damage, but we are picking our poison at this belated juncture. The inflation genie is out of the bottle, the direct and predictable consequence of money creation à outrance over the last two years, by which I mean the most steeply-negative real interest rates in British peace-time history and the continuation of emergency quantitative easing after the output gap had closed and the economy was starting to overheat.
We are now in a surreal situation. Would you have believed it if told after Brexit that sterling would today be higher than it was a decade ago against the Japanese yen, the ultimate safe-haven currency issued by a country in perma-deflation?
The Bank of England’s trade-weighted index for sterling - the one that matters - has risen 8pc since mid-2020 and is above the level just before the pandemic began. It is roughly where it was all through the post-Lehman and early austerity years.
This currency strength is unsustainable. Sterling is arguably as over-valued today as it was in those halcyon days before the global financial crisis, when homeowners in Croydon and Beckenham were dollar millionaires, and the British middle classes could afford a hotel bill in Switzerland.
The UK has been running persistently higher inflation than its major peers for year after year, and ultimately relative price moves are what set exchange rates in a world of free capital flows.
War drums at Threadneedle Street essentially explain the pound’s latest spike. The Bank of England is the first of the major western central banks to raise interest rates, though the US Federal Reserve may shock us next week and join what is fast becoming a stampede.
The pavlovian trade for FX speculators and global-macro hedge funds is to pile into the currency of the first central bank to move, surfing the wave until it starts to roll over. At a certain point they switch sides and go in for the kill. It is the fear of this coming dénouement that keeps me awake at night.
“The party’s over. The peak of the cycle has passed as UK growth slows, in both absolute and relative terms,” says Kamal Sharma, Bank of America’s currency strategist.
Traders have turned net short. Positioning in the currency options market suggests that investors are preparing for a time-honoured sterling treat: after ‘staircase up’ during the boom phase, it is invariably ‘escalator down’ when the music stops.
Paul Meggyesi from JP Morgan said Britain’s stagflation cocktail of rising prices, weaker growth, and a coming fiscal squeeze, is not one that currency traders will tolerate for long.
Bank of America said there was a surge of pent-up inward investment into the UK after the EU-UK trade deal agreed at the end of 2020, inadequate though it was. These inflows led to a balance sheet surplus of 20pc of GDP in the first quarter of last year.
It turbo-charged sterling and masked the UK’s chronic current account deficit: some 4.2pc of GDP even before the winter gas shock. This is red-warning territory for a country with a low savings rate.
Foreign money kept propping up the pound through the year but for a different reason: global wealth funds were buying Gilts and British debt, faute de mieux in a low-yield world.
The UK has been borrowing from fickle global markets to finance what is still one of the highest primary budget deficits in the world, or put crudely to let us live beyond our means. One thing I have learned over the years is that elephantine twin trade and budget deficits usually catch up with a country in the end.
The biggest component of the UK’s stubborn trade gap is now energy. This is why I favour pulling out the stops on every kind of domestic alternative, wherever there is a credible case that it can match or undercut imported gas, oil, and electricity on price. That includes drilling in the North Sea and off Western Scotland, and at this point includes even domestic fracking in the super-rich Bowland Basin, subject to regulation on methane leakage.
It includes a faster roll-out of cheap offshore wind, buttressed by long-term storage in the form of green hydrogen from electrolysis. Let us revive the 8.6 gigawatt Severn Barrage tidal project, abandoned by George Osborne in 2010 on the grounds that the country was then “on the brink of bankruptcy”, as if we were Greece (a sub-sovereign borrower). His solution to this fictional problem was to slash public investment with a high economic multiplier.
The UK is now entering a period of falling real living standards. All key measures of inflation are running higher than pay growth, which averaged 4.2pc over the last three months. The energy shock will hit with a lag after Easter.
“Our central assumption is that regulated energy bills will rise by around 40pc in April. But, without some sort of government intervention, it's entirely plausible that bills will rise by 50pc plus,” said Chris Hare from HSBC.
The markets are pricing in four rate rises this year. Such tightening would feed through gradually to floating mortgages and small business credit. The accumulated effect would not be trivial in such an over-leveraged economy.
The optimistic view is that inflation will subside almost as fast as it rose, and therefore that such rapid tightening will not in fact happen. If so, we might somewhat cynically congratulate the Bank of England for wiping out the Treasury debt burden left from the pandemic through a one-off bust of monetisation, expropriating bondholders just as the Bank and Federal Reserve both did via financial repression in the 1940s and early 1950s to pay for the Second World War.
Peter Warburton, a credit theorist at Economic Perspectives, fears it will not be so simple. He has been warning all through Covid that western central banks have been losing control of inflation - as have monetarists such as Tim Congdon.
Dr Warburton thinks we are in the foothills of a ‘price reset revolution’ that will turn economies upside down, and especially the British economy. “It is becoming increasingly likely that we have embarked on a multi-year reset of the price level, to the tune of 30 to 50 per cent,” he said.
This is the scale of debasement that will be required to inflate away the public debt and the credit-financed promises for pensions, entitlements, and other inert transfers, scattered liberally like confetti. He said our system of private-sector credit allocation has by now been so warped by dirigiste meddling and the mispricing of risk that loans are skewed towards housing inflation (the most socially-destructive kind), and skewed away from productive business. The negative supply-shock has become a structural feature of the credit regime.
Whichever view you take, the strong pound this winter has kept the worst of post-pandemic inflation at bay. It is sobering to contemplate what will happen once the global currency markets turn on us and the inevitable reversal runs its course. As a precaution, I am parking my cash savings in Japanese yen.
A falling pound will be the next inflation shock
The strong pound this winter has kept the worst of post-pandemic inflation at bay