Former Bank of England policy maker Kate Barker said officials may be wary of increasing interest rates if it risks stoking gains in the pound that would undermine Britain’s economic recovery.
“Having a reasonably weak sterling is very helpful, that is certainly a reason why you’d expect a lot of caution on changing rates,” Barker said in an interview in London. “The bank would certainly be uncomfortable if sterling appreciated strongly, because that would solve the inflation problem but it would be depressing the economy at a time when actually you really, really want to see a better current account.”
The pound has gained against 15 of the U.K.’s 16 most-traded currencies this year as soaring inflation prompted investors to raise bets on when the bank will raise its benchmark interest rate. Barker said that exporters, which have benefited from the pound’s 20 percent drop since the start of 2007, could withstand some gains in the currency.
“Rates going up a quarter percent, is that really going to push sterling up and suddenly make this considerable competitive boost from the pound go away? It doesn’t seem very likely,” she said. “But hey, exchange rate forecasting, who can do that?”
Analysts forecast the pound will strengthen next year to 80 pence per euro, the currency of Britain’s biggest trading partner, Bloomberg data show. It was at 84.5 percent per euro late yesterday in London. Inflation reached 3.7 percent in December and Bank of England Governor Mervyn King forecasts the rate may exceed 4 percent, more than twice the 2 percent target.
Policy makers held the key rate at a record low of 0.5 percent yesterday to nurture the recovery, and left their bond-purchase plan at 200 billion pounds ($322 billion). Barker said that during the financial crisis, the weaker pound gave the bank grounds to expect they could salvage the recovery.
“One of the things that made us feel more confident that we could turn the economy around was the fact that sterling fell during the crisis, and we were pretty pleased about that,” said Barker, who served on the bank’s Monetary Policy Committee from 2001 until May last year. Still, “I’m sure the bank doesn’t have a target for the exchange rate.”
Barker said setting policy when inflation is above target and growth has had “the wind taken out of its sails” presents the bank with challenges in preserving its credibility.
“Economic judgments at the moment are very difficult, because the economy is in a difficult state, and the credibility and public perception risks are unusually high,” she said. “It would be quite dangerous if the view that they’re really targeting something else came into play.”
Former policy maker DeAnne Julius said this week that the bank’s credibility has suffered because it hasn’t changed policy amid a 13-month bout of above-target inflation. Barker said there may be other credibility tests.
“If you start putting rates up when the economy’s quite weak, then you start to have the credibility question, ‘Do we really want these people running our economy?’” Barker said. In addition, “If you thought a rate increase was really going to be misinterpreted as the start of some great tightening, then you’d really worry about it, and that’s when communication is going to be incredibly important.”
She also said policy makers are wary of a rate increase creating a big jump in bond yields. The yield on the U.K.’s 10-year gilt has risen 49 basis points this year to 3.88 percent, the highest in nine months.
“The danger you run is that the whole yield curve moves up very sharply and then you have more of an effect on growth than you really wanted,” she said. “It’s one of the many things committee members are dealing with.”
Barker said that whenever the bank starts tightening policy, there’s no reason for it to make big moves. Policy maker Andrew Sentance has been arguing since June for a “gradual” increase in borrowing costs to control inflation.
“It would be a bit odd for the policy choice to be between rates being where they are or moving up to 3 percent,” she said. “In some ways a small rise, a quarter or even half, might be relatively costless for growth.”