Amateur Hour at the Bank of England

At a time that the theater is burning, it is generally not a good idea for the head of the Fire Department to shout “Fire!” and also to say that he intends to fan the flames when the fire gets worse. Yet that is precisely what Bank of England Governor Mark Carney seems to have done in the immediate aftermath of the UK’s vote to exit Europe.

Last Thursday, at a time that sterling was already under considerable pressure, he indicated that not only does he expect that the UK economy will weaken substantially in the period immediately ahead but that the Bank of England stands ready to cut interest rates to prop up the economy.

Before Mr. Carney’s latest remarks, the markets had all too many reasons to fear that we could have a full blown sterling crisis later this summer. After all, the UK chose to have its divisive Brexit referendum at the very time that the country was experiencing an external current account deficit of 7 percent of GDP, the largest such deficit in the UK’s post-war history.

Over the next two years, the financing of such a large external deficit could become problematical as investors will be uncertain about the country’s future relationship with Europe. This would especially seem to be the case considering the tough stance that the UK’s European partners are already indicating that they will be taking in the forthcoming negotiations with the UK on that matter. In addition, one must expect that financial firms in the City of London will relocate part of their operations to Dublin, Frankfurt, and Paris in order to maintain easy access to the single market.

As events of the past few days have underlined, a further factor likely to complicate the financing of the UK’s external deficit is the country’s heightened political uncertainty. In the immediate aftermath of that referendum, Prime Minister David Cameron chose to resign effective in October, which sets the scene for a divisive leadership battle within the governing Conservative Party this summer. Further adding to the UK’s political turmoil has been the challenge in the opposition Labor Party to Jeremy Corbin’s leadership as well as Scottish National Party’s leader Nicola Sturgeon’s call for a second Scottish independence referendum.

Before the Brexit vote, Mr. Carney himself repeatedly warned that the UK’s large external current account deficit made the UK overly dependent on the kindness of strangers to finance it. One would have thought that this recognition alone would have made him realize that it is a singularly bad idea to give hostages to fortune now by effectively committing the Bank of England to ease monetary policy later this summer if indeed the UK economy were to weaken appreciably. If capital outflows were to pick up and if the currency markets were to go into freefall and needed to be stabilized by the autumn, interest rate hikes rather than interest rate cuts would be the appropriate policy response.

Equally troubling is Mr. Carney’s failure to recognize that a very weak currency has the effect of not only raising domestic inflation but also of providing support to the economy through stimulating its exports and constraining its imports. His signal that interest rates would be cut this summer irrespective of where the value of sterling might be seems to indicate a cavalier attitude towards attainment of the Bank of England’s inflation target, which is its primary remit. In a recent study, the IMF estimated that a sustained 15 percent depreciation in sterling could raise inflation by 4 percent which would put the Bank of England’s inflation target in jeopardy.

It is to be hoped that Mr. Carney’s policy misstep last week will soon be corrected and he will provide better economic leadership in the crisis than he has to date. With British politics now totally upended, the Bank of England is the only institution that still has the credibility to provide the country economic direction at this difficult time.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a Deputy Director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.

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