Economics: Hard pounding

Dennis Turner

A claim frequently heard in the opening weeks of the year was that the pound
would be the dollar of 2008.

On top of a fragile consumer, a teetering housing market, an overstretched
public sector and a credit crunch, it seems that a weaker currency is going to
be added to the list of the UK’s current economic woes. If the recent slide in
sterling does continue, it will not only bring problems of its own, but will
also reduce the authorities’ options for dealing with the myriad of overall
difficulties.

During his decade at the Treasury, Gordon Brown was lucky in a number of
important respects, not least in the behaviour of sterling. Almost uniquely
among recent Chancellors, he presided over a currency that avoided the excessive
swings that did so much to destabilise the economy and undermine his
predecessors. In fact, as his tenure ended, a marked weakening of the dollar saw
the $2 threshold breached for the first time in 26 years.

Since Brown switched Downing Street addresses, however, the pound has not
looked quite so healthy. At the end of January, the trade-weighted index was 6%
below its end-October level, 5% down against the dollar and just over 6% against
the euro. The depreciation against the euro has been particularly striking.
Almost unnoticed, it dropped from e1.5079 (66.3p) in January 2007 to e1.3863
(72.1p) by year-end, and has since slipped further to an all-time low of e1.33
(75p). This is almost on the scale of sterling’s decline against the old German
deutschmark, which forced the UK’s exit from the ERM in September 1992.

The interest rate environment in the US, UK and euroland accounted for the
changes in relative values of the currencies last year. After climbing from
4.75% to 5.75% between August 2006 and July 2007, further increases to 6% and
beyond were generally predicted. This supported sterling for much of last year,
but then the climate changed abruptly and the credit crunch – and growing
awareness of problems in the personal sector – led to expectations of lower
interest rates. As a result, sterling weakened in the closing months of 2007.

But this relationship seems to have broken down, particularly against the US
dollar. Interest rate differentials have turned back in the UK’s favour as US
rates have been cut to 3%, while in the eurozone, expectations for rates have
also fallen. Yet the pound has barely responded. There is a growing belief that
sterling’s fall reflects an increasing concern over the fundamental health of
the UK economy. The massive £20bn deficit on the current account of the balance
of payments in Q3 last year (over 5.5% of GDP) is the latest evidence of the
imbalances within it.

Although not the headline-grabbing number that it was in previous decades
(that ‘privilege’ is now reserved for inflation), shifts in the exchange rate
make a huge difference to an economy as open and trade-dependent as the UK (far
more so than the US, for example). For exporters and manufacturing in general, a
fall in sterling will bring some much-needed relief by easing overseas selling
prices. At a time when our major markets are tightening, any boost to
competitiveness is welcome. But against this, industry has to balance higher
costs of imported raw materials, which eventually will feed into output prices.
For the MPC, the big worry is that the 30%, or so, of GDP that is imported will
cost more and add to inflationary pressures, thus restricting the freedom to
reduce interest rates as spending growth slows.

Oil is an obvious example. Until now, the UK has been partly cushioned
against the steep rise in oil prices by the weaker dollar. Oil prices, quoted in
dollars, have not risen quite so sharply when converted into sterling. But, if
sterling continues to weaken against the dollar, this insulation is removed. The
UK has been able to ‘subsidise’ its own domestically-generated inflation
(running at 3.5% to 4.0% a year) by importing deflation from China, meaning the
2% inflation target has been achieved with historically low interest rates. But
as China starts to get more expensive and sterling weakens, we could be
importing inflation to add to our own.

The MPC will then have to work harder to meet the 2% target.

That said, as ever, it is likely that the gloom is overdone. Currency
markets, like equity markets, tend to exaggerate in both directions.
Conventional wisdom has it that this is a correction, part of the adjustment or
rebalancing of the economy that the UK has to endure. Although a weaker currency
will restrict the MPC’s room for manoeuvre on interest rates, the economy as a
whole is better off. While consumers might prefer sterling at $2.25, the
all-important external sector benefits from the pound at $1.95. And when it
becomes apparent the UK is only slowing rather than sliding into recession,
sterling should stabilise. Slightly higher interest rates, however, may be the
price we have to pay to get activity back on a better balanced track.