January 29, 2008 | posted by Michael Baxter in Sterling | comments (0) |

There is a mystery a-brewing. US interest rates are falling like a pig, shorn of its wings, from the sky. And yet the dollar has not fallen in tandem. If you take into account interest rate expectations, then this really becomes quite surprising. Fed chairman, Ben Bernanke, has metaphorically chartered a fleet of helicopters carrying monetary stimulus to try and boost the US economy, but, by contrast, the central bank in the UK still seems to be fretting over inflation and this moral hazard argument – that banks are being bailed out through encouraging them to do more of the same things that created the mess in the first place.

Put all that together and it would appear the gap between US and UK interest rates is set to climb.   Then take into account that Until March last year, US and UK interest rates were the same. Then the Fed lowered rates while the Bank of England raised them.

In the short term there seem to be two main reasons for money to flow into a country. Money will flow in to chase higher interest payments, and it will flow in if the recipient country is seen to be having good economic prospects.

Bear that in mind, and all of a sudden the reasons for the sharp fall in the dollar relative to the pound last year become clear.

But the pound has since dropped back, falling from $2.10 last autumn to this morning’s price of 1.98. So if the expectations for US interest rates are so low, while at the same time the outlook for the US economy seems awful, why has the pound weakened?

It seems there are three possible explanations. Explanation 1: markets believe the Bank of England will change its tune, and will soon join the Fed in a race to see who can cut interest rates the quickest. Explanation 2: markets expect the UK economy to go the way of the US, and slow, possibly even toying with recession. Explanation 3: things are actually working the way the economic text books say they should, and the pound is at last responding to the fact the UK suffers from a massive deficit on its current account.

Recently, the deficit in Britain’s balance of payments current account as a percentage of GDP overtook the deficit seen in the US, but even that doesn’t tell the full story. One theory doing the rounds is that the official figures on Britain’s balance of payments deficits understate the reality, because the figures don’t accurately reflect the extent to which UK company profits have occurred overseas.

It was about this time last year that Warren Buffett said he was getting out of dollars; there was no magical reason for his decision. He decided the US current account deficit was too high.

Economists have for some time dismissed current account deficits as not really mattering  if capital flows into the country with the deficit increase.  It is certainly the case that both the US and UK are on the receiving end of massive capital flows.

Maybe, though, investors have become more discerning. Sovereign Wealth Funds are demanding an awful lot more bang for their buck, while the dollar and perhaps the pound have lost much of their appeal to investors.

Maybe this is the true reason for the credit crunch, foreigners are no longer happy to pump money into the economies of the Anglo Saxon world for such a lousy return.

And what is the lesson for this story? It is that in the long run, deficits in the balance of payments current account do matter, after all. For years, economists have dismissed as groundless, fears that the US balance of payments deficit would end in tears, saying this was as about as likely as pigs flying. Well, it seems that just may have happened. The economic pig may have taken to the wing.  

December 20, 2007 | posted by Michael Baxter in Sterling | comments (0) |

“It ain’t the rate of interest that’s the problem,” said Airbus Jean-Claude Trichet, yesterday, “it’s the lack of credit.”

You will recall, yesterday, the President of the European Central Bank took Helicopter Ben (Bernanke’s) idea for solving a credit crisis by scattering money across the land a step further. Mr Trichet and his ECB cohorts announced an extraordinary 349 billion euro cash injection, propting us to nick-name him Airbus Jean.

You would have thought, after pumping all that money out there, the ECB would be lowering interest rates soon. But yesterday the great cash splatterer told the European parliament “the risks to price stability over the medium term are clearly on the upside.” He also said that price stability requirements and the need to get banks to start lending again are separate issues.

Naturally, banks and commentators saw red at those words. Kevin Gaynor, Head of Economics and interest-rate strategy at RBS in London told Bloomberg “It can’t have temporary support for the market stretching into six months and yet maintain the fig leaf that monetary policy is based on an unchanged view of economic risks.”

But, Mr Trichet could be right. The crisis we are seeing at the moment is not down to official interest rates, it’s down to market interest rates. Central banks want us to lend and borrow at one rate. The markets are forcing this level higher although, by the way, interbank rates do seem to falling.

Meanwhile, in the US, Federal Reserve Bank of Richmond President Jeffrey Lacker said “Because the job of a central banker is to protect the purchasing power of currency, it is overall inflation that we need to keep down, not just core inflation…I am uncomfortable with the inflation picture.”

Yet, in the UK, after the Bank of England dropped a size 10 hint that interest rates are going to fall several times next year, markets started to work out the ramifications.

The pound fell. At the time of writing it stood at $1.99, the lowest level since June. We predicted yesterday that if the Bank of England really does slash interest rates next year, the pound is likely to be the casualty.

Not that this would necessarily be a bad thing. If the UK could find it is able to export its way to growth, that would be be good news indeed, although it could lead to more inflation.

But was we have said before, when both the US and UK suddenly start importing a good deal less, but export more, it is naive to believe the global economy can just carry on regardless.