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Analysis
Carney's risks

Carney's risks

Questionable commitment to rate cuts 

by Desmond Lachman in Washington

Fri 1 Jul 2016

When the theatre is burning, it is generally a bad idea for the head of the fire department not only to shout ‘Fire!’, but also to say that he intends to fan the flames when the fire gets worse.

Yet that is precisely what Mark Carney, the governor of the Bank of England, appears to have done in the immediate aftermath of the UK’s vote to leave the European Union. In a speech on 30 June, he indicated that he expects the UK economy to weaken substantially in the near term, and that the Bank of England stands ready to cut interest rates to correct matters.

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

To make matters worse, as events of the past few days have underlined, the ‘Brexit’ vote has upended UK politics and injected considerable uncertainty for at least the next two years regarding the UK’s relationship with Europe.

Carney repeatedly warned before the vote that the UK’s large external current account deficit made the country overly dependent on the ‘kindness of strangers’ to finance it.

One would have thought this recognition alone would have made him realise it is a singularly bad idea to give hostages to fortune by effectively committing the Bank to easing monetary policy later this summer if the economy weakens appreciably.

If capital outflows pick up and the currency markets need to be stabilised later this summer, as is all too likely given the UK’s deepening political crisis, interest rate hikes rather than cuts would be the appropriate policy response.

Equally risky is Carney’s failure to recognise that a very weak currency has the effect not only of raising domestic inflation but of supporting the economy by stimulating exports and constraining imports.

Carney’s signal that interest rates would be cut this summer irrespective of the value of sterling might seem to indicate a cavalier attitude towards attaining the Bank’s inflation target – its primary remit.

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 Chief Emerging Market Economic Strategist at Salomon Smith Barney.

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