Manly Money: British Dilemmas

Let me see if I get the British –Macarena told me late last night—.
Number one: inflation has been increasing and now exceeds the comfort limit of 3%, to the point that for the first time since the Old Lady was made independent, the Governor of the Bank of England had to write the dreaded, and legally mandated, “explanation letter” to the Chancellor.
Number two: the British Pound has appreciated beyond the US$2 mark for the first time since 1992, an event terrible, linked to the infamous Black Wednesday affair.
Number three: the conventional wisdom rationalizes this apparent paradox (accelerating inflation + currency appreciation) by invoking the expectation of future interest rate hikes: Since people anticipate tighter (more expensive) money tomorrow, they view today´s prices as cheap.

Hmmmm.

A simple country-girl, you know, Macarena does not get it. In her simple world, if inflation were indeed a serious concern, investors would punish the Pound and we would observe currency devaluation, as well as nominal interest-rate increases and a steepening of the yield curve. Her arguments are:
1. The real interest rate reflects economic fundamentals, mostly productivity. Evidence shows that, if anything, various measures of productivity in the UK slightly outpace those observed elsewhere. Real interest rate determinants are thus either constant or slightly to the downside.
2. Nominal interest rates are a monetary (and expectations-related) phenomenon. Monetary conditions, as suggested by the slope of the yield curve (actually, inverted) and by the exchange rate, suggest that monetary conditions are not expansionary. Given the fact that a relatively important current account deficit exists (about 3.5% of GDP), a factor excercising force towards to the weak side, the currency´s behavior perhaps even implies quite the contrary....
3. As mentioned by the Governor in his letter, energy prices have a lot to do with the bad outcome observed in March.
4. Conclusion: Monetary tightening, such a manly thing, is responding to temporary one-time relative price swings. The expectations generated by its almost inevitable course, is indeed the leading cause of the accelerating inflation-strenghtening currency paradox.
Macarena´s view: Down the road, “true” inflation will be revealed as being much more in line with fundamentals, i.e much closer to the 2% goal, and pressure will build to lighten up on monetary policy. In Macarena´s view, and she is a contrarian, monetary authorities should take it easy and stay put, instead of acting virile now, and reversing course later, perhaps even this year.