Mervyn King Sends Sterling Lower; Inflation Risks Outweighed by Pro-Growth Policy

Outgoing Bank of England Governor Mervyn King sent the pound lower against major pairs Wednesday following the publication of the Bank of England's Quarterly Inflation Report.

The report and the ensuing press conference reiterated the Bank's stance to maintain loose policy, even as inflation creeps higher, near the Bank's target.

The Quarterly Report, King's comments, and comments from current Bank of Canada Chief Mark Carney, who is set to replace King at the Bank of England, over the past 30 hours have shown a resiliency from the Bank of England to keep rates low and keep policy loose until growth picks up.

Even as inflation rose at an annual rate of 2.7 percent in January, well above what economists see as a normal 2.5 percent rate of inflation, the bank does not see medium term inflation risks and thus decided to keep policy loose.

In the report, the Bank said, "Inflation has remained stubbornly above the 2% target. Despite subdued pay growth, weak productivity has meant no corresponding fall in domestic cost pressures. And increases in university tuition fees and domestic energy bills have added to inflation more recently. CPI inflation is likely to rise further in the near term and may remain above the 2% target for the next two years. But inflation is expected to fall back to around the target thereafter, as a gradual revival in productivity growth dampens increases in domestic costs and external price pressures fade."

"UK banks' funding costs have fallen further, aided by the improved financial environment and the Funding for Lending Scheme (FLS). And there is growing evidence that this is feeding into private sector credit conditions: many loan rates to households and companies have fallen and some measures of credit availability have improved."

The bank also noted that growth is likely to remain weak in the near term and pick up later, aided by a better global back drop. However, they understand that the Eurozone and its debt woes as well as issues in emerging markets pose serious threats to an uptick in growth.

The pound sterling dropped on the news sharply against most major pairs including the U.S. dollar and the euro. The pound fell 0.68 percent against the dollar, or 107 pips, to 1.5556, near 6-month lows. Also, the EUR/GBP cross rose 0.86 percent, or 66 pips, to 0.8663 as the euro gained against its British counterpart. The pound also fell 0.69 percent against the yen.

British shares reversed earlier losses on the news as the FTSE 100 Index rose 0.14 percent. Miners such as Rio Tinto RIO, Glencore, and Xstrata rose along with other economically sensitive sectors as investors became more confident in the Bank of England's efforts to prop up the economy.

Gilt yields rose as well, showing a pure risk-on environment in English assets following the report. 10-year Gilt yields rose nine basis points to 2.19 percent, the highest level in 10 months. 2-year Gilt yields rose as well by four basis points to 0.36 percent. Also, the cost of insuring U.K. debt rose 0.5 basis points to 52.50 basis points.