Inflated expectations are driving up sterling

INFLATION is the curious way in which, over time, the same amount of money buys progressively less stuff. So it was strange to see yesterday that, as a result of higher than expected inflation in Britain, the value of sterling hit its highest level in two months. Against the dollar, the pound rose by about 1 per cent. Theoretically, all else equal, a rise in inflation ought to weaken a currency, not strengthen it – Zimbabwean dollars are not worth very much right now. So why is sterling rising?

Well, all else is not equal. The Bank of England (BoE) has a mandate to maintain CPI inflation at 2 per cent, plus or minus one. Persistently high inflation – CPI inflation is now running at 3.7 per cent – could well force the monetary policy committee (MPC) to raise interest rates, which would in turn lead to an appreciation of sterling. Anticipating that, traders spent yesterday buying up sterling.

But the question traders should now be asking is whether the market has been too optimistic. Many economists are urging that interest rates be held steady to protect the economic recovery. One MPC member, Adam Posen, has even called for further quantitative easing. Might not rates be kept at 0.5 per cent for a while yet?

Certainly it seems a possibility. While British inflation is curiously high among developed countries, dovish economists point to external causes. Sterling has depreciated by about 20 per cent against a basket of currencies since the start of the financial crisis in 2008, increasing the cost of imported goods. Moreover, the RPIY measure of inflation, which excludes indirect taxation, is closer to 2 per cent – VAT increases account for much of the rise in prices. Finally, rising commodity prices, which have increased the price of food and petrol, are universal and temporary, and so not necessarily a cause for alarm.

Based on that logic, economists at the ITEM club, a forecasting group sponsored by Ernst and Young, predict that CPI inflation will drop back below the 2 per cent target by 2012, even without a rate rise. If the MPC agrees with that analysis, then they will likely refuse to raise rates, and so sterling will depreciate from yesterday’s highs.

Others are less sanguine. Julien Holmes, chief operations officer at Crown Mortgage Management said: “With inflation as persistent as it is, it is hard to justify keeping rates as low as they are. The Bank of England has a clear credibility issue and if they don't do something soon, inflation expectations will just keep trending up.”

Holmes argues that the British economy may be operating much closer to capacity than is realised, and so rate rises eventually will be inevitable. Even if the BoE stays dovish for the moment, if the markets expect rate rates later, the appreciation may still last.

And as Richard Wiltshire of ETX Capital pointed out, the BoE is “unlikely to be comfortable with the current state of affairs” – and the markets know it. The issue for the BoE is how to dampen inflation expectations without strangling the recovery or initiating a dramatic leap in sterling.

For the moment, however, it seems likely to adopt the dovish line. Traders would seem well advised to cut their long positions then. Inflation is rarely a good thing.