Bank Of England Made Sterling Vulnerable To “Flash Crash”

  • The underlying cause of the flash crash was not politicians, not Brexit and not algorithmic trading, it was Bank of England (BoE) easing.
  • The real problem is that the BoE’s monetary easing goes the opposite way to other major countries: the Fed, ECB and BoJ are all talking about tighter policy now.
  • The UK’s easing is justified neither by short-term data nor by any medium-term adjustments related to Brexit.

Last week’s flash crash, which saw the pound fall more than 6 percent in a few minutes, has been blamed on computerised algorithm trading and on statements by politicians in France and the UK. But the real underlying source of sterling weakness can be seen as the words and actions of the Bank of England, which in August introduced an interest rate cut and aggressive bond purchase programme with open hints of much more to come. Within weeks, all other major central banks signalled moves in the opposite direction. This has left the pound vulnerable, given the dominant role of monetary policy in foreign exchange markets.
Since Mark Carney and his colleagues eased policy, the Fed has stepped up signals of tightening, with investors now assigning a probability of over 60% that it will raise interest rates in December. The Bank of Japan abandoned its earlier trend towards easing, in favour of a mixed policy that includes upward pressure on longer-dated bond yields. And the European Central Bank also changed course in a tighter direction, hinting at an early tapering (gradual withdrawal) of its own bond purchase programme. They are doing this against a background of global inflation starting, finally, to edge upwards. With all three major central banks going in the opposite direction to the Bank of England, it is unsurprising that the pound can fall sharply after relatively insignificant political rhetoric, and that such moves can be compounded by automated trades.

The short-term economic situation provides no clear rationale for the Bank of England’s August stimulus. When the Bank acted, business surveys had been published that showed a large fall in confidence just after the Brexit vote, which Bank interpreted as suggesting a risk of a severe slowdown or recession. But historically after other major events, similar large moves in business confidence have reversed very rapidly, as the shock wears off and people reassess. That is exactly what happened in this case, with surveys subsequently bouncing back strongly. And the hard statistical data have shown the UK economy moving ahead at a reasonable pace, with just one figure, manufacturing output, looking slightly weaker while three major areas, exports, consumer spending and jobs, are all expanding at a good pace.

The medium-term risks caused by Brexit also provide little justification for easy policy now. It is possible that the UK’s real exchange rate might in future need to decline somewhat to compensate for the imposition of tariffs on trade with Europe and other adverse economic effects such as tighter restrictions on immigration. But this is a very uncertain area indeed, with the actual terms of Brexit still to be negotiated and their implementation likely to be subject to transitional periods perhaps lasting some years. So it does not seem appropriate for the central bank to be setting monetary policy now to accommodate a future exchange rate adjustment that is unknown, and may well not be needed at all. Especially since a fall in the real exchange rate that might be required, and that might not achieved at all by a nominal decline now, if UK wages and prices rise in response to inflationary pressures.

In short, the Bank of England has made a policy mistake and is now well out of line with its major peers around the world. As a result, it has made the pound vulnerable to further large declines like the recent flash crash, as well as risking upward pressure on bond yields that are difficult to control, despite its purchases, because inflation starts to rise. The Bank should change policy, first by signalling that further rate cuts are unlikely, and then by indicating that the probable next step is to put rates back up again and end bond purchases, reversing the August action.

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