MNI INTERVIEW: BOE Likely Understating Impact Of Sterling Fall

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

currencies.

     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

said.

     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.

     --BOE AWARE OF PROBLEM

     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

spending.

     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: jason.webb@marketnews.com

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