COLUMN-Rate trap? BoE and sterling snared by rate frenzy: Mike Dolan

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(The author is Editor-at-Large, Finance and Markets at Businesshala News. Any views expressed here are her own)

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LONDON, Oct 8 (Businesshala) – If the Bank of England falters in its rate-raising plans, it is increasing the risk of triggering a trap door for sterling.

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All central banks are at a difficult point, slowly acknowledging that post-pandemic inflation will last longer than previously thought as winter energy costs heat up and economies cool off.

Whether the lack of fuel increases the deceleration is a moot point. But with long-term inflation expectations building up, there is increasing market pressure for policymakers to take back control and maintain credibility in their targets.

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For many, this is fertile ground for policy mistakes.

Efforts to rein in credit and consumer demand to contain what the International Monetary Fund and Organization for Economic Co-operation and Development see as a temporary supply-side inflation shock may seem distorted.

Still, a growing number of smaller central banks with tighter inflation targets have already pulled the trigger, with New Zealand, Polish and Czech interest rates rising in the past week.

The US Federal Reserve and the European Central Bank are far from it, but both are preparing to reduce, slow down or recalculate bond purchase programs. In contrast, the People’s Bank of China is moving in the opposite direction and is already preparing to ease policy again.

The Bank of England appears to be stuck in the middle and finds itself at the forefront of the G4 reserve currency countries most likely to raise rates first.

Largely thanks to its own rhetoric, the BoE encouraged markets to fundamentally bet on the UK’s first interest rate hike in early 2022, although Governor Andrew Bailey acknowledged that there was indeed some more extreme supply Couldn’t do anything to ease the problems.

But as European gas prices have risen, with truck shortages and petrol supply problems partly related to Brexit, markets have turned ballistic. By some measures they now see a 50-50 chance of a small increase in the 0.1% BoE policy rate by the end of the year – a full year ago they are also thinking of a similar Fed move.

Two-year gilt yields have nearly doubled to 0.47% last month. The underlying UK 10-year inflation expectations in the index-linked bond market added a third of a percentage point above 3.9% over the same period and stood at levels seen only fleetingly since the BoE became independent in 1997. Happened.

While the latter is at least a percentage point more distorted than the more accepted consumer inflation gauge – as it is still indexed in the old retail price index – it still means that the market will target CPI inflation to the BoE’s 2% target for years to come. Expect to stay above that.

What’s more, the BoE’s own survey of UK companies this week showed their 1-year ahead inflation view rose 30 bp to 3.5%.

And, unlike the Fed, the BoE has no new mandate for a more flexible averaging of that target over time.

Trap for Sterling?

Yet the pound – as measured by the BoE’s effective exchange rate index – has found little consolation from the rate hike frenzy.

Sterling fell to its lowest level in 7 months at one point last week as UK inflation scarred relative real yields and investors feared that initial rate hikes would only slow the economy further and narrow the policy rate horizon further. Will do it

This week’s report suggested UK households will face a more than 30% increase in winter energy bills, underscoring concerns and any parallel increases in loan and mortgage rates, leaving many workers vulnerable. There seems to be a brutal reaction to the limit of overkill.

But there is no easy option. On the other hand, UK home prices rose at the fastest rate for nearly 15 years, despite the end of the tax break last month.

Edward Park, chief investment officer at Brooks McDonald, believes the bond market moves sound ‘scary’, but says, “It is important to differentiate between what the market actually believes and what the pricing means. “

He added that despite the volatility, the jury remains on the extent of the inflation problem and the BoE’s potential response.

Oxford Economics strategist Xavier Corominas believes it is time to “sell fear of UK inflation”, despite understandable concerns given the UK’s structural vulnerability to inflation over the past 50 years.

“The market has overtaken itself in pricing in extremely high long-term inflation expectations,” he wrote. “At just 4% over the next decade, we see an opportunity to enter a short ten-year break-even inflation anticipation tradeoff.”

The problem for Sterling is what happens if the BoE no longer matches the newly-aggressive rate expectations, which have helped stoke and begin to potentially guide the market at the end of the year amid continuing inflation concerns. Is.

And if this adds to the sterling deficit, how much will it complicate the BoE’s task by raising import prices?

Huw Pill, the new BoE chief economist, did little to talk the market back from his forecasts on Thursday, emphasizing that “the magnitude and duration of the transient inflation spike is proving to be higher than expected.”

At least, there is a delicate communication task ahead and Pound can now be overly sensitive to every detail.

By Mike Dolan, Twitter: @reutersMikeD; Editing by Alexander Smith

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