The Bank of England Could Be Forced to Raise Rates This Year

 | Jan 20, 2017 | 8:00 AM EST
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It seems improbable now, but the Bank of England at some point this year may be forced to raise its interest rate. If not, it could risk a full-blown currency crisis.

Bank of England Governor Mark Carney had said repeatedly that the bank was willing to "look through" inflation if it exceeds its 2% target in order to ensure the economy keeps growing. This stance has ensured that foreign exchange speculators have been unable to pinpoint a level for the exchange rate that they could mark as the central bank's "pain threshold."

But earlier this week, the governor blinked. He said monetary policy could respond in either direction -- in other words, that the interest rate could go up from its record low 0.25%. Before his statement, the British pound had fallen to a level of $1.1986 -- a 30-year low vs. the dollar if we ignore last October's flash crash -- on investors' fears about what a "hard Brexit" could do to the U.K. economy.

The pound has recovered some ground since then, especially after a speech by Prime Minister Theresa May in which she confirmed the U.K. would be leaving the European Union's single market. However, Carney's intervention has given speculators a level that they can test.

Of course, it is unlikely that the Bank of England will hike rates as soon as the pound goes below $1.1986. Indeed, the central bank has been willing to "look through" inflation despite the hardships it causes poor families in the U.K. to suffer because of high housing costs that are due to asset price inflation brought on by record low interest rates.

It also has been willing to "look through" depreciation of the currency even as the pound lost around 17% against the dollar since last June's Brexit vote. But it is a matter of degree. How much more depreciation can the Bank of England tolerate? Another 5%, or 10%, or even 20%?

Supporters of the Leave campaign are delighted by the weakness of the pound and point to the rise in exports and manufacturing as a side effect. However, these gains are accompanied by unfettered access to the world's biggest trading bloc. This access will end in a little more than two years.

Besides, there is very little talk about what the weak pound does to the country's external obligations, especially those to the European Union. Prime Minister May has said the U.K. still wants tariff-free trade with the EU, at least for some sectors. Let's not forget she persuaded Nissan to keep investing in the north-east of England by promising that nothing much will change for the carmaker after Brexit.

According to various reports, the EU insists that Britain cough up as much as 60 billion euros ($63.8 billion) for various budget payments it already has committed to and for the cost of pensions for the British employees of the union over the country's four-decade membership. This bill will grow more expensive the weaker the pound becomes.

Finally, there is a political cost to inflation that the government cannot "look through" even if the central bank can. Also, the prospect of turning into a tax haven for the wealthy and for multinationals is unlikely to sit well with the working- class voters who supported Brexit in large numbers. The Bank of England might find the government encouraging the central bank to act.

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