Saturday 10 April 2010

The Bank of England shows their hand – UK Bank Rate held at 0.5%

The Bank of England this week held interest rates at 0.5% for the fourteenth month in a row. I’ve been speculating over the past few months at what the Bank of England are up to but I’m now convinced I know the strategy of the Bank of England and unfortunately it’s not their officially published Monetary Policy Framework of keeping to the Government’s inflation target of 2%. It’s clear that’s not the strategy when the Retail Prices Index (RPI) is running at 3.7% (annualised 3 month RPI is 4.8%) and the government set Consumer Price Index (CPI) is running at 3.0%.

So what is the Bank of England up to? Well I’m sure the official line that we will all continue to hear over the coming months will be not unlike Mervyn King’s last open letter to the Chancellor. That is that current inflation is a ‘temporary deviation of inflation from the target’, ‘short-run factors on inflation should only be temporary’ and that ‘inflation is more likely than not to fall back to the target in the second half of this year’.

I don’t buy it any more. I think the Bank Of England are now going to keep the Official Bank Rate low for a long time and allow inflation to run as high as they can get away with trying to raise interest just before it gets out of hand. If it works who will this strategy help:
- The banks. They will be able to continue to rebuild their balance sheets by borrowing very cheaply and lending out at much higher rates.
- The reckless. Those that borrowed far too much including the government. They’ll be able to sit back and watch inflation erode the value of their debt.

So who will the strategy hurt:
- The prudent. Those that saved and tried to take responsibility for their own actions. Whatever assets they have built up will be devalued as inflation erodes their value.

This is a very dangerous game to play as if the markets become convinced this is the strategy the Bank of England are playing at then the following could occur:
- The pound (GBP) could further devalue pushing up the price of all imports forcing inflation even higher.
- Rising debt costs as investors demand a higher yield on their gilts to compensate for the inflation. This would then cause interest rates to rise in the real world whether the Bank of England likes it or not.
- In an extreme a bond strike meaning there would be nobody to buy UK debt. This could then lead to a visit from the International Monetary Fund (IMF). We must remember that the Bank of England has bought more than the total debt issuance of the UK government over the past year through their Quantitative Easing (QE) program which in my opinion is nothing more than a posh word for printing money.

Already it appears as though I’m not the only one starting to think that inflation is going to continue. The Telegraph recently reported that US bond fund PIMCO has said that “the UK was now on its list of must avoid countries, with Greece and others in the eurozone’s Club Med.” They are saying that the “flood of British debt is likely to lead to inflationary conditions and a depreciating currency”. The market is clearly becoming suspicious. Will the Bank of England get away with it?

Meanwhile on the other side of the world what appears to be a prudently run country, Australia, has had its central bank, the Reserve bank of Australia, raise interest rates by 0.25% to 4.25% this month. This is despite their CPI inflation sitting at 2.1%.

As always DYOR.

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