The Bank of England may be forced to pay greater attention to the UK economy outside of London when setting interest rates.
That’s the conclusion of a study by Deutsche Bank into whether the UK fulfils the criteria of an optimum currency area. It says the British capital skews the performance of the overall economy, potentially masking weaknesses, creating asset bubbles and distorting labour markets elsewhere.
“The implications are that monetary policy may need to display a regional bias to take account of asymmetrics,” said Oliver Harvey, a London-based macro strategist at Deutsche Bank. “We find that interest rates have historically been biased towards London, but believe that this may change.”
Such an environment could mean BoE governor Mark Carney and colleagues use tools other than interest rates if they want to restrain London-led house increases, while waiting for signs that manufacturing and construction are recovering as well as services before tightening monetary policy, said Mr Harvey.
“For the Bank of England to raise rates it will need to see a broad-based recovery,” he said. “It will look at the aggregate data as it makes policy for the whole of the UK, but it’s relevant to raise the question of regional costs and benefits.”
The power of London may be helping speed the UK’s economic recovery, which has helped lift the 10-year bond yield to 2.9%, from about 2% at the start of the year, and 108 basis points over German bunds. Deutsche Bank doesn’t anticipate the central bank lifting its key interest rate from 0.5% until Nov 2015.
As Scotland debates whether to split from the UK, Mr Harvey found sterling’s economy may fare worse as a currency bloc than eurozone, whose single currency only began trading in 1999.
The reason is differences in the economic and financial performance between London and the rest of the country, which means the UK’s business cycle is uneven and imbalances risk forming, Deutsche Bank said. Per capita wealth in London is double that of the UK average and widening. Accounting for deviations in output across the country suggests the UK is the third most unequal nation in the European Union behind only Belgium and Slovakia.
Since 1979, London has been the one area of the UK whose performance has not moved almost in lockstep with the rest of the country.
As of 2011, its output when measured by gross value added was around 13% of UK’s total compared to New York’s 6% share of US production.
“It could be argued that excluding London, the UK actually presents ideal conditions for a successful currency area,” said Mr Harvey.
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