Central Banks and Credibility: A Laughing Matter?

It is funny how central banks continue to carry so much gravitas among investors and traders. Perhaps never have central bankers – particularly the Fed – ever [seemingly] lacked so much credibility in the public eye. Maybe it’s the fact that these power brokers have the markets and the economy by the b@||$ – we are at their mercy.

Anyway, here are some comments from Bloomberg regarding the Bank of England:

Former MPC member Barker says the BoE has experienced a ‘modest loss of credibility’ as the MPC has tolerated a higher level of inflation since the financial crisis.

Ok, I suppose I can see how kneejerk reaction would be to question the usefulness of the monetary policy commission, assuming they sit idle while inflation pressures rise.

But 1) there is a good chance the price pressures are temporary and tightening down rates would exacerbate economic difficulties in the UK, and 2) I was sent this article from reader – an excerpt is below:

Mervyn King is Britain’s chief central banker and a key figure in the global financial system. Last week, after surprising reports surfaced that the British economy had once again contracted in the 4th quarter of last year, King delivered a stern, sobering message to his country:

– “In 2011, real wages are likely to be no higher than they were in 2005… One has to go back to the 1920s to find a time when real wages fell over a period of six years.”

– “The Bank of England cannot prevent the squeeze on real take-home pay that so many families are now beginning to realise is the legacy of the banking crisis and the need to rebalance our economy.”

– “The squeeze on living standards is the inevitable price to pay for the financial crisis and subsequent rebalancing of the world and UK economies.”

– Furthermore, inflation may rise “to somewhere between four per cent and five per cent over the next few months.”

– “The idea that the MPC could have preserved living standards, by preventing the rise in inflation without also pushing down earnings growth further, is wishful thinking.”

– “[U]npleasant though it is, the Monetary Policy Committee neither can, nor should try to, prevent the squeeze in living standards, half of which is coming in the form of higher prices and half in earnings rising at a rate lower than normal.”

– “I sympathise completely with savers and those who behaved prudently now find themselves among the biggest losers from this crisis.”

To summarize, one of the world’s leading central bankers has looked his country in the eye and admitted that he is completely powerless to prevent the inevitable decline in living standards that will result from years of reckless behavior.

The reader also asked what we thought about the British pound, particularly if we thought it was the best candidate to sell short. Our answer, with some additional explanation, is below:

Based on the tight correlation numbers (nearly 90% over the last month) between the pound and the S&P 500, we think that if/when stocks crumble the UK fundamentals will play catch-up with the pound and drag it lower (perhaps very fast.)

That said, the article passed on [above] is very good in that 1) you rarely see such a candid statement from a guy in King’s position – it is quite refreshing, actually; and 2) he is taking the approach that what is happening, while it is quite uncomfortable, is necessary in cleansing the economy and working off the current economic burdens that plague their recovery efforts – this tack could very much benefit him and the UK (and eventually GBP) in the longer-run.

For now, though, we think the biggest risk for GBP is easily to the downside.

A collapse in stocks and general risk appetite would likely be spurred on by some sort of risk event. The turmoil in Egypt has yet to seep in to the markets. The China-front has been relatively quiet as the battle for who’ll manage a slightly better, sub-par recovery — the US or Eurozone — takes center stage.

A mere technical pullback in US stocks, admittedly long overdue by most market watchers, could also do the trick. At that point, though, we would need to reevaluate how currency traders are digesting the fundamentals coming out of the UK.

As risk appetite appears more and more extended, we think a short bet on GBPUSD is a fairly safe bet. Well, as safe as possible, anyway …

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