By Brian Swint
July 27 (Bloomberg) -- Bank of England Governor Mervyn King may beat Ben S. Bernanke to the emergency exit.
King, 61, will be in the vanguard of a global push to raise interest rates next year as he grapples with the highest inflation expectations in the Group of Seven industrialized nations, say economists at Goldman Sachs Group Inc. and Deutsche Bank AG.
Higher rates may bolster the pound, which has slumped about 17 percent against the dollar in the past year, and keep a lid on inflation as Britain’s economy rebounds from its deepest contraction in half a century. Those gains may come at the expense of exporters, such as building materials supplier SIG Plc, that have reported increased sales on the lower currency.
“The Bank of England could be the first out of the stable,” said Willem Buiter, a professor at the London School of Economics and a former central-bank policy maker. “If it goes too early, it might abort a fragile recovery and create a painful appreciation in the pound. If too late, it may be perceived as weak on inflation.”
The Monetary Policy Committee will prepare new forecasts this week for the Aug. 6 interest-rate decision. After the nine- member panel cut the benchmark rate to a record-low 0.5 percent in March, the U.K. should see “some evidence of positive growth in the second half of the year,” policy maker Andrew Sentance said in a July 23 Bloomberg Television interview.
The British economy contracted 0.8 percent in the second quarter, the government reported last week. That followed a 2.4 percent decline in gross domestic product in the first three months of the year, the most in half a century.
Inflation Outlook
The U.K. inflation rate will be the fastest in the G-7 next year, the Paris-based Organization for Economic Cooperation and Development predicts. Investors expect it to be the highest on average among major industrial economies over the next decade.
Britain’s 10-year break-even inflation rate is 2.36 percent, compared with 2 percent in Canada, 1.98 percent in Italy, 1.88 percent in the U.S. and 1.77 percent in Germany. The rate, an indicator of inflation expectations, is the difference in yield between index-linked government debt and conventional bonds of equivalent maturity.
“The U.K. has had more stimulus relative to elsewhere, as well as lower sterling,” said George Buckley, chief U.K. economist at Deutsche Bank in London. “We may well be the first to hike rates. The pound will recover if the economy recovers more quickly than elsewhere.”
Underestimating Strength
Investors may be underestimating the strength of the British economy, said Stephen Jen, managing director of macro and currencies at BlueGold Capital Management LLP in London, which has $1.3 billion in assets under management. The pound’s decline has gone too far, he said.
The currency’s depreciation, which raises the cost of British imports, is one source of inflationary pressure. Another will come with the Jan. 1 expiration of a tax break that will raise the U.K. sales tax to 17.5 percent from 15 percent.
The lower pound is a boon to exporters such as London-based Smiths Group Plc, the world’s biggest maker of mechanical seals for energy and marine customers. The company made almost half its sales last year from North America. For every cent the pound drops, the company’s earnings before interest and tax rise by 1.2 million pounds ($1.9 million), according to analysts at Numis Securities Ltd. in London.
Sheffield, England-based SIG, Europe’s largest supplier of insulation and roofing materials, said July 10 that sales in the first six months of 2009 climbed 1 percent in pounds from a year earlier, while falling 9 percent in euros. SIG says it generates about 50 percent of its revenue from the European continent. The pound has declined 8.8 percent versus the euro in a year.
Competitive Currency
“The U.K. has got a really competitive currency for the first time in 20 years,” said Jim O’Neill, Goldman Sachs’s chief economist in London. “It’s something you want to hold on to. If I were on the Monetary Policy Committee, it’s something I’d think about.”
HSBC Holdings Plc increased its forecast for the pound’s appreciation on July 23, saying the currency will rise to $1.75 by the end of next year, from about $1.64 last week. Previously, the bank had projected it would stay near $1.61 in 2010. The HSBC team led by David Bloom, global head of currency strategy in London, predicted that the Bank of England may stop buying assets next month and will lift rates before the Federal Reserve.
Brown’s Prospects
Higher borrowing costs may further dim prospects for Prime Minister Gordon Brown, who has trailed the opposition Conservatives in opinion polls for more than a year and must call an election by June 3.
Brown gave the Bank of England operational independence in 1997, soon after taking over as Chancellor of the Exchequer under Tony Blair. The decision now prevents him from controlling the central bank’s actions.
“Gordon Brown won’t like any rate increase early next year,” said Stewart Robertson, an economist in London at Aviva Investors, which manages 236 billion pounds of assets. “But it’s an independent central bank, so tough.”
Buiter said the Bank of England may start increasing interest rates around the middle of 2010 and the Fed may wait until 2011. Chairman Bernanke said July 21 that while there are “tentative signs of stabilization” in the economy, the Fed will be “highly accommodative” for “an extended period.”
Flooring It
“Central banks have got their foot to the floor and the wheels are spinning in the mud,” said Steven Bell, who runs a $222 million hedge fund at GLC Ltd. in London. “But if the wheels get traction, we could get a very sharp recovery. The U.K. has the best prospects of the major countries, and growth will be stronger than people expect.”
The Bank of England has been a trendsetter before: King’s decision to buy gilts in March came before Bernanke’s purchases of government bonds, an approach sometimes called “quantitative easing.” Now, King’s exit strategy may give global policy makers a model to follow or show them pitfalls to avoid.
“The Bank of England has been by far the most aggressive major central bank in what they’ve done with quantitative easing,” said John Wraith, head of sterling product development at RBC Capital Markets in London. “They need to be careful about overdoing it because inflation has been sticky.”
BOJ’s Blunder
Clamping down too early on incipient inflation has come back to haunt policy makers in the past. The Bank of Japan raised interest rates in 2000 only to cut them again months later after the dot-com boom went bust.
The Fed, by contrast, kept rates low through the first half of 2004, and its hesitation to start lifting them helped fuel the housing bubble that preceded the start of the U.S. recession at the end of 2007.
Bank of England policy makers said the economy may be stronger than expected and the inflation outlook a little higher than in the last projections published in May, according to minutes of the July 9 meeting published last week. They declined to extend the program to buy 125 billion pounds of assets with newly created money until they come up with forecasts for the August decision.
“A key aspect to the strength of recovery is how central banks navigate out of the stimulus,” said Scott Thiel, the London-based head of European fixed-income at BlackRock Inc., which has $1.37 trillion under management. “An ill-timed exit strategy is potentially disastrous.”
To contact the reporter on this story: Brian Swint in London at bswint@bloomberg.net.
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