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The Bank of England Just Kept Calm and Carried On

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Postcards featuring the World War II British slogan "Keep Calm and Carry On" are seen outside a newsagents in London, on 24 June, 2016. Photograph by Leon Neal—AFP/Getty Images

The Bank of England surprised financial markets by keeping its key interest rate unchanged and holding off from any more stimulus, if only for a month.

The pound spiked to its highest level this month and stock and bond prices both fell as the BoE’s Monetary Policy Committee voted by 8-1 in favour of sitting on its hands, but markets probably won’t have long to wait for the expected action.

“In the absence of a further worsening in the trade-off between supporting growth and returning inflation to target on a sustainable basis, most members of the Committee expect monetary policy to be loosened in August,” the BoE said in a statement announcing its decision.

Governor Mark Carney had said after the U.K.’s vote to leave the European Union on June 23rd that he expected that the Bank would have to relax monetary policy to support the economy. Its Financial Policy Committee has already loosened capital requirements on U.K. banks in an effort to protect the economy from the initial shock that has hit financial markets. Rebecca Harding, chief economist at the British Banking Association, said she expected such ‘macro-prudential’ measures, rather than traditional monetary policy ones, to gain in importance as the effects of the Brexit vote play out.

But despite signs of a sharp shock to consumer and business confidence, the MPC appeared to come to the conclusion that the drop in the pound’s exchange rate since June 23rd was enough of an easing of monetary conditions in itself for now. The pound’s trade-weighted exchange rate has fallen by 6% since the referendum, making U.K. exports more competitive and making inward investment cheaper. The U.K. has the largest current account deficit in the G7 and is dependent on “the kindness of foreigners” to cover that gap through the capital account.

But two other factors may also have influenced the bank’s decision: for one thing, interest rates are already at a historic low (0.5% for the key refinancing rate), and monetary officials across the world are divided over whether zero or negative interest rates actually do more good than harm.

“Lower rates are unlikely substantially to increase lending; the immediate effect on the economy is also likely to be limited as a result,” the BBA’s Harding wrote in a blog post ahead of the MPC meeting.

Secondly, as the MPC implied, there was no hard data on which to justify a first policy easing in seven years, so to have done so would have reeked of panic.

Finally, it’s a consistent theme across history that central banks are most likely to act when there is a temporary paralysis or vacuum in government.

That was still the case last week when Carney spoke about the likely need for further stimulus: the governing Conservative Party was still expecting to take until September to appoint a new leader and Prime Minister. However, that process accelerated in recent days as Theresa May’s challengers all fell by the wayside, leaving her to take the leadership unopposed.

May immediately signalled that her government will tolerate a higher budget deficit to support growth in the next four years, removing one of the reasons for the Bank of England to loosen monetary policy immediately. To underline her point, May has sacked Treasury chief George Osborne, who had aimed to balance the budget by 2020, and replaced him Thursday with Philip Hammond. (For more details of Theresa May’s new cabinet, click here.)

The top official appointed by May to lead the U.K.’s negotiations with the EU on the ‘Brexit’ process is David Davis, a man who has indicated that controlling immigration will be mo

By 0815 ET, the pound was trading at $1.3385, up 1.8% from its close on Wednesday but still 7% below where it was before the referendum. But market participants still expect it to head lower as the economy starts to suffer later this year.

“BOE stimulus will come, eventually, and therefore we still see sub-$1.30 as a more likely destination for (the pound-dollar rate) by the fourth quarter,” said Nawaz Ali, a currency strategist at Western Union in London.