Company News » Economics: Sterling effort

Economics: Sterling effort

Speculating on exchange rates is notoriously difficult, but historically a weak pound has destabilsed the economy

Aspiring economists used to be advised that when they got to the bit about
exchange rates in a discussion, they should always give a rate and always give a
date, but never both in the same talk. This reflects the fact that the exchange
rate is the most speculative of all the indicators to predict. Despite the most
sophisticated models and the best efforts of an army of chartists and analysts,
movements in the major currencies always seem to defy rational analysis and
surprise markets.

Most of the UK’s major economic crises since 1945 have involved the exchange
rate, especially the devaluations of 1949 and 1967, and the ERM debacle in 1992.
Although it has been a while since ‘a sterling crisis’ or ‘a run on the pound’
created panic among policymakers, or mayhem in markets, it would be wrong to
take the stability of the currency for granted. The potential for a volatile
exchange rate to destabilise the economy and re-ignite inflationary pressures
remains and, in the coming months, changes in the global economy could put
downward pressure on sterling.

The long period of interest rate stability (only one change in the last 21
meetings of the MPC) is largely attributable to the fact that inflation has been
behaving itself. Only briefly last year, when oil prices were rising towards $70
a barrel, has the Consumer Price Index (CPI) exceeded the 2% target since it
became the official measure at the start of 2004. This may surprise many people
who see their council tax charges and bills for gas, electricity and water
rising at double digit rates and the prices of many services items increasing at
twice the CPI rate.

The overall inflation index, however, is a weighted average of a typical
shopping basket and this average has been kept down by the ‘goods’ component.
For several years, these prices were falling and now, although positive, are
rising at an annual rate of less than 1%. China’s rapid expansion as a producer
and exporter of manufactured goods has been a major contributory factor of these
low prices. Sterling, a key determinant of import prices, has also been a
positive in keeping inflation low, but this may be about to change.

For all the fancy analyses produced by currency strategists, the key
fundamental explaining exchange rate movements is the expected differential in
short-term interest rates. The weakening of the dollar against sterling a couple
of years ago can be understood in this context, as can the recent surprising
strengthening of the greenback, despite the structural problems of the US
economy. There are occasions, of course, when the link between exchange rates
and interest rates breaks down, as during the dotcom frenzy of the 1990s. But,
as a framework for looking ahead, it remains the best starting point.

For the first time since January 2001, rates in the US are higher than in the
UK. In each of its last 15 meetings, the US authorities have raised interest
rates. From 1%, the Fed funds target rate has climbed to 4.75%, with even more
on the horizon. US rates are expected to be 5.5% by summer, while in the UK
there is little sign of a change from 4.5% in either direction.

This is why the US, despite struggling with a large fiscal deficit and an
even larger balance of payments deficit, has seen its currency hold its value
over the last 12 months. And with the prospect of further rate rises in the
pipeline, the widely-predicted period of dollar weakening is on hold.

Changes in Japanese monetary controls have contributed to the new lease of
life for the yen. The ending of the policy of quantitative easing will probably
push up short-term interest rates, so strengthening the currency. Although
higher energy costs have curbed the country’s traditional trade surplus, it has
been offset by a surge in its earnings from investment flows, which adds to the
upwards pressure on the currency.

In the EU, the outward signs are for a pick-up in activity, which spells a
stronger euro. Although the inflation risk has probably been exaggerated and the
likely strength of activity overstated, interest rate increases seem likely in
the coming months. While the rate in euroland will remain lower than in the UK
even after the rises, the differential will narrow, making the euro a more
attractive currency.

At the same time, slowing growth, a widening trade deficit and rising
unemployment are taking the shine off the UK economy and making sterling a less
attractive currency. A pound travelling south, of course, means higher import
prices, just as the CPI is pushing up against its target.

The MPC, therefore, could be pulled in two directions. Upwards pressure on
inflation spells higher interest rates, while a slowing economy needs lower
rates. The exact impact of a weaker currency will depend on how far the pound
falls and whether the old rule of a 10% decline in sterling adding 1% to prices
still holds. It should make for an interesting debate.

Share
Was this article helpful?

Leave a Reply

Subscribe to get your daily business insights