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By David Robinson
     LONDON (MNI) - The Bank of England risks substantially underestimating the
upward inflationary pressure from sterling's depreciation due its practice of
using trade weights to assess the impact of currency movements, a senior
academic and adviser to lawmakers told MNI.
     Dennis Novy, former trade adviser to the House of Lords and affiliated to
the University of Warwick and the London School of Economics, stressed how much
trade in the modern world is carried out in currencies that are neither those of
the importing nor exporting country. This renders trade weighted indices, of the
type used by the BOE, obsolete.
     If trade weights are used rather than invoicing currency weights, "you will
underestimate the impact of exchange rate fluctuations on prices, on inflation,"
Novy said.
     Novy and his fellow researchers looked at detailed customs invoicing data
and found that usage of "vehicle currencies" - which are neither the importer's
nor exporter's - was pervasive. Some 55% of the UK's non-EU trade is in vehicle
     Swathes of trade with India and Japan, for example, are conducted in U.S.
dollars, Novy said. This diminishes the economic importance of many bilateral
exchange rates.
     The impact "is roughly twice as big through to consumer prices" if
pass-through is estimated using currency weights rather than trade weights, Novy
     His research found that exchange rate pass-through was around 24% based on
bilateral exchange rates but almost 60% when based on vehicle currency rates.
One implication is that policymakers should construct a new exchange rate index
based on invoicing currency weights.
     The BOE part-funded Novy's research and its economists are well aware of
the problem, with Novy saying that he knew Bank staff were working on the issue.
     BOE Governor Mark Carney, in his Aug. 23 Jackson Hole speech, touched on
the issue, setting out some of the big picture challenges that "dominant
currency pricing" throws up for policymakers.
     Carney noted that the dollar is the currency of choice "for at least half
of international trade invoices, around five times greater than the U.S.'s share
in world goods imports."
     The BOE quarterly Inflation Report, however, and August's Brexit
illustrations, were based on the trade-weighted sterling Exchange Rate Index
rather than any currency invoice weighted measure. A 5% sterling ERI
appreciation in the event of a Brexit deal, for example, was shown knocking 0.4
percentage point off the consumer price index a year down the line.
     Novy recommends that policymakers should update their "rules of thumb" for
predicting currency impacts on prices. Brexit uncertainty has led to sterling
having the highest implied volatility of any advanced economy currency,
reinforcing the need for policymakers to try to get a more accurate fix on
likely pass through to prices of potentially large moves.
     Another strand of Novy's work has been to try and quantify how Brexit
uncertainty has fuelled a flow of investment from UK firms into the euro area.
     "It is a one-way street, of money flowing out," he said, with both a demand
and supply side effect, as it reduces supply side capacity while also hitting
     For BOE staff working on the projections for the next Inflation Report, due
out on Nov. 7, just a week after the end-October Brexit deadline and with
reports flying of a potential general election that month, their forecasting
challenges only look set to intensify.
--MNI London Bureau; +44 203 865 3829; email:
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