The Conflicted Bank of England

OXFORD – Andrew Sentance, an outgoing member of the Bank of England’s Monetary Policy Committee, has outlined a credibility-challenging scenario for the BOE. There are two contradictory forces that could keep inflation significantly above its 2% target not only this year and next year, but even in 2013.

The dilemma is that any depreciation of sterling increases the level of imported inflation that is not offset by spare capacity in the economy. In other words, the United Kingdom has spare capacity – output fell by 6.4% during the recession and has not fully recovered – but not enough of it. Thus, inflation has been above the BOE’s target throughout the recovery from the financial crisis of 2008. And, according to Sentance, it could stay above that target for the BOE’s two-year medium-term forecast window.

Worse still, if Bank of England Governor Mervyn King is right that above-target inflation is due to imported inflation, raising interest rates has little impact unless it induces sterling appreciation, which would reduce the cost of imports. But, sterling depreciation is supposed to re-balance the economy by increasing exports. Indeed, the British government is counting on that. Its new Office for Budget Responsibility forecasts trade contributing as much as consumption to GDP growth in the coming years.

Of course, that means closing the current account deficit, which has been about 1-3% of GDP, and that, in turn, implies further weakening of sterling. Obviously, sterling can’t appreciate and depreciate simultaneously.