The Two Dollar Pound

by Adrian Ash

Forex traders just love the pound. But the pound loves them more…

“Savings income normally has 20 percent tax taken off before you get it,” as the British government notes on its Direct Government website.

Anyone trying to save money today will also know that inflation is also deducted at source.

Ten years ago this May, the current administration – New Labour – swept to power with the greatest electoral majority since the end of WWII. And the first announcement made by Gordon Brown, the new finance minister, gave full operational independence to the United Kingdom’s central bank, the Bank of England.

By way of thank you, the Bank has given the nation record price stability – or so you might think. The Old Lady has tweaked interest rates and twiddled the knobs of monetary policy so deftly, she has abolished the risk of runaway inflation, but also steered clear of the dreaded deflation, too.

Hence the two-dollar pound hit on the news that Consumer Price inflation (CPI) in March 2007 rose to 3.1%. Forex traders the world over, expect higher sterling interest rates to counter this higher cost of living. Inflation running at a 16-year high makes better yields on the pound a slam-dunk.

But peer through the other end of the telescope for a moment. With the pound so strong, why is inflation in the U.K. rising so quickly? And rather than speculative flows being a mere by-product of tackling inflation with higher rates, isn’t a stronger pound the only way to prevent inflation – already at a 16-year high – from running ahead faster still?

Since gaining independence, the Bank of England has built itself a fantastic reputation for inflation-busting. That’s despite presiding over the greatest flood of money growth in the U.K. since the huge bubble-top that preceded the collapse of its housing market – and the collapse of sterling that followed – at the end of the ’80s.

Under Mervyn King, the current governor of the Bank, the pound was the first of the world’s top five currencies to gain higher interest rates after the “Deflation Scare” of 2003. The BOE jumped to raise its rates seven months before the U.S. Fed started hiking dollar rates off their half-century floor of 1%. (The European Central Bank took until Dec. 2005; the Japanese and Swiss have only just got round to it.)

Mervyn King also loves to talk the talk of “zero tolerance” in the fashion of Bundesbank heads during the ’70s, repeatedly warning that he’s not afraid of higher rates ahead if necessary. He even makes occasional reference to “rapid money and credit growth” – so at least he knows there’s a problem.

“I am surprised it has taken ten years and 120 meetings of the Monetary Policy Committee before a [1.0%] deviation of inflation from target,” he’s now said in response to the latest Consumer Price data. The governor is mandated to send the chancellor an open letter explaining why CPI inflation is off-target if it moves too far away from the Bank’s target of 2.0% per year.

And according to Dr. King, he relishes this opportunity to explain his policies.

But his open letter reveals little of the Bank’s immediate policy response. And despite gaining such kudos from the forex markets, all the Bank of England has really given British voters during the last decade – as Tuesday’s awful cost-of-living data proves – is a collapse in the real rewards paid on cash savings.

That, plus a bubble in property prices to surpass even the top of 1989.

Over the last 10 years, real Sterling interest rates have shrunk to their lowest level since the late 1970s. Come March 2007, and even ignoring the deduction of basic-rate tax, real returns paid to cash savers in Britain fell to just 0.45% – their lowest level since the “Deflation Scare” of mid-2003. In the summer of that year, spooked by the threat of inflation vanishing altogether, the Bank of England cut its base rate to a half-century low. Real interest rates dropped to a two-decade low of 0.40%.

The stock market leapt higher. House prices rose at their fastest pace in history. Household savings rates shrank towards zero. And no wonder. You now have to go back to May 1981 to find British savers enduring a worse rate of return on cash-in-the-bank post inflation.

Now the Bank of England is expected to raise base rates to 5.50% at its May meeting. Unless inflation falls away dramatically, however – an unlikely event given that inflation in energy prices slowed in March, only to be overtaken by soaring prices for milk, bread, furniture and furnishing, large electrical goods and even computer games – then holding cash on deposit will continue to teeter on the verge of costing British citizens money.

After tax, that other government-inspired deduction at source, British savers are already under water.

And if Mervyn King fails to make good on the currency market’s expectations of higher rates, the pound looks fated to fall – fast – pushing the rate of inflation yet higher again.

Editor’s Note: Adrian Ash is the City correspondent for The Daily Reckoning in London and is formerly the head of editorials at Fleet Street Publications Ltd. He has been studying and writing about the investment markets for the last 9 years, and is now head of research at BullionVault.com – giving you direct access to investment gold, vaulted in Zurich, on $3 spreads and 0.8% dealing fees.