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Can the Bank of England Save Sterling?

The latest inflation number for the UK economy is punchy. The analysts were looking for CPI at a little over 2.5 percent - the annualized figure as delivered is 3 percent. April came in at 0.8 percent. Food and energy prices are making it hard for the Bank of England to cut interest rates. This should be supportive for the British pound. But the market smells blood.

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The broader economic picture in the UK is deteriorating almost everywhere you look. The British Retail Consortium says retail sales in April fell 1.5 percent below the same month last year. That is the second negative report – coming after a 1.6 percent drop in March. The BRC said clothing and footwear were the weakest areas.

The latest report from the RICS institute – a body of professional surveyors – says house prices fell in every region in April. They reported the widest margin of decline in 30 years; evidence the slow down in the housing market is picking up pace. Metrics like the number of transactions or prospective buyers are collapsing.

Against this backdrop, the Bank of England will tomorrow produce its quarterly inflation report. The bank has argued inflation will moderate later in the year as labor prices decline, but as headline oil and food prices continue to tick up the market is not so convinced. And the bank has struggled to address the concerns of independent economists about the slow-motion rolling over of the UK growth cycle.

As Michael Browne, our guest host from Sofaer, pointed out this morning, the bank is actually powerless to respond. The tool of monetary policy works best with demand-pull inflation – where domestically generated inflation from higher wage settlements can be slain with tighter money.

Monetary policy is constrained where the inflation is a consequence of cost-push from higher commodity prices. Setting a policy of easier money for slowing growth and falling asset prices will not address the inflation threat – meantime, keeping rates high to choke off the second round effect of higher commodity prices leading to higher wage settlements risks stalling growth.

While the UK economy was on firmer footing sterling benefited from the interest rate lead it enjoys over all other developed world currencies. Even if the BOE shaves another quarter point off rates at the June meeting (for growth over inflation) it will still have a considerable rates spread over the dollar and euro. But it won’t matter. Falling property prices and slowing consumer spending will drive the market away from the pound – after all government finances are not robust enough to offset a decline in the private sector economy with higher public spending.

The pound would respond to noises from the bank that rates may stay on hold or indeed go higher – but politically that would be a difficult message for the government or the consumer to swallow.

Michael Browne was mostly cautious on equities. Browne says June will be critical for the banks as they focus on cash levels at the close of the second quarter, and for corporates as they review their ability to raise cash and secure credit lines. Michael is taking a wait-and-see attitude on growth and earnings. His bias is deep value, where much of the risk is already in the price.

Just some more anecdotal evidence. I agree with Michael Brown. I am a long term ABN "high value" customer. Fortis are making a mess of it. I am also thinking of moving assets out. Fortis bank branches are scruffy compared to ABN. There is no cultural match.

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