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Flash Crash Of Pound: Challenges For Central Bank

19/10/2016 14:51

On Oct 7, the pound suffered a flash crash with the dollar to sterling rate being reported to be falling as low as $1.1378 dropping by almost 6% in one Asian trade. With this free fall in the sterling, major outlying trades were cancelled. The question as to why this happened has left many baffled. Some factors that have been stated behind the flash crash are a possible technical glitch due to algorithmic trading and tough comments from the French president Francois Hollande on Brexit negotiations. Data from the Bank of England demonstrates that the sterling is on a continuous depreciating path-spot exchange rate of US dollar into sterling depreciated 17.6% since the Brexit referendum vote on June 23, earlier this year. This raises many challenges for the Bank of England in trying to stabilize the economy.

Inflationary pressures

The first and foremost impact of the depreciating sterling is on inflation. Current inflation stands at 0.6% but according to Bank of England Governor Mike Carney, it is likely to overshoot the Bank's official 2 percent target over the coming years. The fall in the sterling is also expected to push up the prices of imported goods or those items which are produced using imported inputs. This has already been witnessed in the case of sterling oil and gas prices with the August 2016 inflation report by the Bank of England, detailing that they have increased in the past three months. Inflation has a multi-pronged effect on the economy which is why price stability is of key concern to any central bank in the world.

Creeping inflation also has the effect of decreasing the real wages of individuals. According to the Office for National Statistics, there are almost 3.5 million non UK nationals working in the UK, which make up almost 12% of the UK labor force. The real wages of all these labor force participants has gone down with rising inflation. This will have an effect of a decline in household consumption and an overall economic slowdown. Inflationary pressures are not the only challenge that the Bank of England has to deal with. An uncertain outlook of the sterling and the economy in general holds far more detrimental consequences.

Uncertain economic outlook

The flash crash of the sterling and its general decline since the Brexit referendum has given rise to general uncertainty over the likely future course of the UK economy. According to the Economist, analysts at UniCredit, an Italian bank said that investors are perplexed by the country's vision on immigration, openness and business friendliness. This might also be a crucial reason behind recent depressed credit conditions in the UK.

Even though interest rates remain low at 0.25% and liquidity remains ample, the Credit Conditions Survey for 2016 Q3 released by the Bank of England highlights that secured lending for house purchase both for prime lending and buy to let have fell significantly. Analyzing from the perspectives of banks, the uncertainty is compounded furthermore. With news that the government is on course to undertake a 'hard' brexit (departure from the single market and the European customs union), banks also face the added uncertainty of whether they would remain in London or stationed elsewhere in Europe. In this scenario if the subdued demand for loans continues, then banks would invest their funds in risk free government securities, popularly known as the 'lazy banking' model in academic literature. Experience from other countries narrates that if 'lazy banking' kicks in then it is difficult to reverse it and can pose a big challenge for central banks to give boost to the economy. Hence, a depreciating sterling does not only hold the risk of portfolio rebalancing by investors in favor of non sterling currencies but also hypothetically by banks in favor of government securities.

To sum up, the depreciating sterling holds challenges for the British government and the central bank. Although the flash crash of the pound can be attributed to algorithmic trading, but it has more to do with general business sentiment following the Brexit referendum and a series of speeches at the recent annual conference of the Conservative party. Uncertainty can prove to be detrimental if not effectively managed at the right time and can give rise to tough challenges for economic managers and central bankers alike.

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