The UK Budget Did No Favor to the Pound
Announcing the U.K. Government budget on Wednesday, Chancellor George Osborne disappointed those who wanted to see a big change in the Bank of England's mandate. The pound strengthened a bit as a result. But I don't think those who are waiting to see the pound weaken, like me, will be disappointed for long.
The Treasury sets the goals for the Bank of England every year in a "remit letter" that it releases in March as part of the budget. The central bank's mandate has been to keep inflation at 2 percent "at all times." There had been a lot of talk before the budget about possible radical changes to this mandate, such as changing the period from "at all times" to "over the medium term" or "over the long term;" raising the inflation target or changing it to a band; or perhaps changing what measure of inflation they target.
(Read More: Osborne Paves Way to Retool Bank of England)
In the event the chancellor made only a relatively small change. The wording of the remit remains exactly the same: that inflation should be 2 percent "at all times." The main difference is that the new remit letter gives the central bank permission to allow inflation to exceed the target even for a fairly long period if the Monetary Policy Committee judges that eventually it will come back to its target level.
In other words, inflation must be kept to 2 percent "at all times" except for times when the Bank of England decides not to. Chancellor Osborne also affirmed that the central bank is free to use unconventional monetary policy tools to promote growth, which it has been doing since 2008. In short, his changes finally formalized the existing policy framework that has allowed the central bank to pursue the policies that have weakened the pound so much.
The decision was positive for the pound insofar as many of the wilder ideas floating around the market beforehand were not included. However, the negative policy mix for sterling continues, which is why I still think it's likely to decline over the medium term. Chancellor Osborne is sticking with his "fiscal responsibility and monetary activism" policy, but the budget showed he's slipping on the fiscal responsibility side.
The Office for Budget Responsibility raised its deficit forecast for the next five years by around 15 percent and said that net debt won't begin falling until 2017-18, a year later than planned and the second time the debt target has slipped. That means he will have to work even harder to tighten fiscal policy.
Yet with the official forecast for growth this year falling in half to only 0.6 percent, he'll need to have the Bank of England be even more activist on the monetary side to keep the economy from falling into recession. And a tight fiscal/loose monetary stance is the textbook recipe for weakening a currency.
That's because a tight fiscal policy tends to slow the economy – which is exactly what's happening in the U.K. right now – and a loose monetary policy tends to increase the money supply – which is what's finally happening, too. The opposite, a tight monetary policy and a loose fiscal policy, tends to strengthen a currency, by raising interest rates and increasing growth. When both policies are tight or loose, the implications are unclear.
At the same time, the Bank of England's Monetary Policy Committee is aware of the risk that people might think it was letting inflation rip. The minutes of the committee's most recent meeting showed that some members were concerned that further monetary stimulus might "lead to an unwarranted depreciation of sterling if it were misinterpreted as a lack of commitment to maintaining low inflation in the medium term."
This comment in support of sterling was in fact more surprising and probably more market-moving than the tinkering with the central bank's remit. It may mean the end of verbal intervention to weaken the pound.
But will it deter them from easing further? Inflation expectations are well within the recent range, meaning that so far, there is no such "misinterpretation" to prevent further easing. And as for an "unwarranted depreciation of sterling," the Organization for Economic Co-operation and Development (OECD) estimates that it's at virtually fair value against both the U.S. dollar and the euro on a purchasing power parity basis, which demonstrates that there is no unwarranted depreciation either.
Meanwhile, the country's weak growth, deeply negative real yields (the lowest among the G-10), widening current account deficit, falling North Sea oil output, worsening terms of trade, dependence on the sickly euro zone economy…need I go on? make for a poor outlook for the currency. I still expect the pound to weaken further.
The author is the Head of Global FX Strategy at IronFX, an on-line trading firm specializing in Forex, CFDs on U.S. and U.K. stocks, and commodities. He was previously Head of the Forex Committee at Deutsche Bank Private Wealth Management.