Last month, the Bank of England (BOE) announced the results of its Monetary Policy Committee meeting. Given the recent trend of global currency debasements, I found the highlight to be their analysis on inflation in the UK. The evidence strengthens my belief that the current environment in the UK spells trouble for the British pound, and therefore why I think it is the least attractive European currency. 

The UK has implemented an inflation targeting regime with a target of 2% (plus or minus 1%), with a stated horizon of two years.  However, a look at the chart below, provided by the Bank of England, shows that inflation, as measured by the UK Consumer Price Index has been above trend since mid-2005, with forecasts suggesting that it could stay there until at least the first quarter of 2016. And yet there has been no direct policy response to bring down inflation. This is not entirely unexpected. In fact, Chancellor George Osborne and Governor Mervyn King have made numerous references to reconsidering aspects of the inflation targeting regime, and incoming Governor Mark Carney has openly discussed the idea of additional and unconventional policy measures that would effectively do the same.

Bank of England’s Forecasted CPI Shows Higher than Target Inflation Likely

Source: Bank of England Inflation Report, February 2013. Target inflation of two percent represented by black horizontal line. Future data is a projection which may not be achieved.

The statements and actions from the current and incoming central bank officials have affected the future effectiveness of the BOE’s monetary policy, and certainly do not bode well for the value of the British pound. Despite rates at the zero bound, and what I see as the most aggressive quantitative easing program among all central banks, the UK economy continues to grow at an anemic pace, restrained by ongoing consumer deleveraging caused by the unwinding of the nation’s housing market bubble.  The UK is marked by slow growth; above-target inflation with rising inflation expectations; negative real interest rates combined with quantitative easing and growing current account deficits. 

The Link between Inflation and Weakened Currency

Over the past year or so, the strength of the British pound has moved in line with pricing of relative inflation expectations between the UK and its major peers such as the U.S. and Europe. It has weakened against both the U.S. dollar and the euro when UK inflation expectations have risen compared to those of the U.S. and Europe. I’ve used inflation swaps as a proxy for the market’s expectations of future inflation, the chart below shows the dollar versus the pound, but the trend applies to the euro versus the pound as well. If inflation expectations in the UK continue to be higher than target, which I expect they will, it is likely that the pound will continue to weaken.

The Pound Falls When Markets Think UK Inflation Will Increase

Source: Bloomberg as of 2/6/13. Inflation swaps are a form of inflation derivative and can be used to represent market expectations of future inflation. Past Performance does not guarantee future results.

For me, the bottom line is that if the UK is on a mission to explore additional policy measures to reflate the economy and tolerate higher inflation for longer periods of time, then underperformance of the British pound will likely be a consequence. Hence, I believe that the British pound is currently the least attractive European currency. 

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