An extraordinarily accommodative monetary stance in the euro zone, combined with expectations that the Bank of England will begin hiking rates sooner rather than later, should continue to support sterling against the euro and, in turn, weigh on the medium-term inflation outlook in the UK.
Moves in the sterling exchange rate continue to exert a significant impact on inflation and activity in the UK, especially at a time while the Bank of England (BoE) and the European Central Bank (ECB) are treading diverging monetary paths, Bank of England Governor Mark Carney argued on Thursday.
"...Developments in the exchange rate have been important for UK inflation and activity, and in particular we have experienced persistent exchange rate pass-through to headline inflation. This risk is particularly relevant at present when the monetary policy stance of our largest trading partner is diverging with ours," Carney said.
"Sterling has appreciated around 18 per cent over the past two years and around 7 per cent since the turn of the year. This will exert a drag on inflation both through lowering import costs and by lowering world demand for UK goods," the governor argued.
While the ECB is set to keep its monetary policy stance extraordinarily accommodative to support the fragile economy within the single currency bloc, the policy stance in Britain is expected finally to lift off the lower bound after more than six years of record-low interest rates.
Carney's notes on sterling in his Thursday's speech partly echoed similar comments he made on Tuesday this week at the UK Treasury Select Committee when he said:
"... In respect to monetary policy is that large moves of sterling have in the past, and it appears to be in the present, had a persistent impact on inflation. In other words, the pass-through has not been immediate, it has shown up over time, and it shows up including over the horizon of monetary policy ... the horizon which we can affect inflation."
"So if there are large movements and there is evidence of persistent pass-through it is harder to just look through those adjustments. That said, we have to be careful .. this does not equate to reacting to short term moves, and in no way would one expect tightening financial conditions because of strength of sterling to remove the need for some adjustment in interest rates at this junction," Carney said.
But Carney also added that the BoE did not "take a view on the level of the exchange rate. There is no informal target level nor informal one, and one of the strength of the monetary policy framework in the UK has been not just inflation targeting, but a commitment, and a demonstrating commitment, to freely floating exchange rate ... Even with the large move [of sterling] it matters, but it is not the dominant factor in term of outlook for inflation."
When questioned by WBP Online during the May Inflation Report press briefing on those sterling moves, Carney said: "Relative to the February Inflation Report to close of business yesterday, we've seen a 4% increase in the effective exchange rate of sterling … We'll have to try to determine what's happening with past pass-through but we have some future pass-through if these types of moves persist, which we'll have to address."
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