One Whiff of Rate Increase and Currency Traders Pre-Empt Policy

Updated on

Central bankers in Europe have their hands tied by currency markets.

Take the Bank of England. Governor Mark Carney said in mid-July the time for higher interest rates was getting closer. On Thursday, U.K. policy makers said the stronger pound would hold inflation lower for longer than they’d expected, making an imminent move less likely. The Czech central bank said the same day the koruna was getting in the way of its price-growth targets.

The concern for policy makers is that, with interest rates near record lows around the world, the faintest whiff of an increase is sufficient to draw a flood of cash in their direction. That has the same effect as tightening policy and makes central banks reluctant to act.

“So long as inflation doesn’t turn around, a strengthening currency will indeed be a hindrance,” said Alvin T. Tan, a foreign-exchange strategist at Societe Generale SA in London. “One of the first incidents came long ago in the Swedish krona. We’ve seen similar developments in the U.K. and Czech Republic.”

Riksbank Reversal

Sweden is an example of how falling prices and a stronger currency can force a central bank to reverse direction on monetary policy. After starting to normalize policy in 2010, within a year and a half the Riksbank embarked on a series of rate reductions as its krona surged against the euro.

Switzerland’s response to a surging currency and tumbling prices was to impose a cap on the exchange rate. Back in January, it abandoned the ceiling, relying instead on negative interest rates.

The Czech National Bank maintained a cap on its koruna and left interest rates unchanged on Thursday. It said it would keep the stimulus measures for at least another year as currency appreciation pushed back the horizon for reaching its inflation target. Traders testing the central bank’s resolve have pushed the koruna to the brink of its 27 per euro limit.

The issue affects central bankers beyond Europe. In the commodity-dependent Andes economies, officials are reluctant to cut rates for fear their already weak currencies will keep falling, fanning runaway inflation.

Sterling’s Gains

With consumer-price growth stagnating in Britain, the BOE’s Monetary Policy Committee voted to hold the U.K.’s main rate at a record low, where it has been since 2009.

U.K. officials are picking over how lasting the effects of the appreciating pound will be on inflation. On a trade-weighted basis, sterling is near the strongest level since 2008 and has gained 11 percent versus the euro in the past year, peaking at 69.36 pence last month. It was at 70.88 pence per euro as of 12:33 p.m. in New York.

Most BOE officials said the reason they didn’t vote for a rate increase at this week’s meeting was the inflation outlook, and said sterling’s advance in the past three months would weigh on price growth for longer than they’d previously expected, according to the minutes.

Cutting Outlook

The central bank reduced its outlook for consumer-price gains. It forecast that prices would rise an average of just 0.3 percent this year, down from an estimate of 0.6 percent in May. Officials see inflation accelerating to 1.5 percent in 2016. Their target is 2 percent.

The strong pound means U.K. rates won’t rise before the end of this year, according to Daniel Vernazza, a London-based economist at UniCredit SpA. Even so, broader economic growth, including wage increases, signals higher borrowing costs in the future, he said.

Carney gave a similar signal at a press conference in London following the rate decision. He said that while the pound was weighing on inflation, it didn’t entirely remove the need for higher borrowing costs.

“There’s been a big move,” Carney said. “There’s no question that the persistent strength of sterling is having an impact on policy.”

For more, read this next:

Before it's here, it's on the Bloomberg Terminal. LEARN MORE