Monday, November 17, 2008

Economics Weekly : How Low Can Sterling Go?

The pound has been falling sharply in the past year...

Sterling has fallen sharply in the past year, down by 20% on the trade-weighted index. The fall against the dollar and the euro has been as deep or deeper, with depreciation of 29% and 16%, respectively. What is going on and how low can sterling go against the dollar and the euro, and what would be the implication for price inflation and hence for monetary policy? In the past, sterling declines of this order would lead to rising price inflation (see chart a) and a subsequent rise in interest rates that would weaken the economy and so help to keep inflation in check, but the Bank of England's view is that inflation will remain low this time. The reasons are that the economy is in recession, making it very difficult for price rises to be passed on by firms (though this may mean profits fall and so unemployment ends up being higher), commodity prices are now falling after rising to record highs in mid 2008 and, crucially, wage inflation is receding, as unemployment rises and employment prospects dim. the inflows from overseas required to fund the trade deficit slows...

The UK runs a trade and current account deficit, which means that inflows of capital from abroad are required to balance its external accounts. But with short and long term interest rates having fallen and the issuance of gilts likely to rise quite sharply, as the UK government spends and borrows more to help offset the recession, the returns for foreign investors have fallen. Hence, they are not purchasing as much UK gilts and bonds and so the exchange rate has fallen, partly in order to make these assets cheaper in foreign currency terms and therefore more attractive to buy. Moreover, with the prospect of further interest rate cuts and increased government spending ahead, the currency is adjusting lower in anticipation of this becoming reality. So, given these trends, how much further can the pound fall against the US dollar and the euro? We focus on these currencies because together they account for nearly 70% of UK exports and imports, and therefore largely determine the path the trade-weighted index (TWI) takes going forward.

...and this is happening because a range of factors that determine its long run value have moved against it...

We have identified six key variables that are critical to the long run direction of the Trade Weighted Index (TWI): short term interest rate differences, long term interest rate differences, inflation differences, and differences in productivity, current account positions and budget deficits. There are, of course, other factors that affect a currency's value, such as the political climate, the willingness to accept foreign investment and investment flows. However, these are difficult to model or show a relationship that can be depicted clearly in statistical estimates.

Looking at the six key variables that compare the UK economy against the US and the euro area shows that almost all have deteriorated in the last two years. Where they have not, there is little or no improvement in the UK's relative performance, leaving a fall in sterling the most likely outcome from where it started two years ago, which in any event was a high level historically. In terms of current account deficits, the UK position has worsened versus the US and euro area in the last two years, and quite sharply versus the latter. For the fiscal position, although the UK's position has improved against the US in the last few years, it has worsened against the euro zone, meaning a fall is more likely in sterling versus the euro than sterling versus the US dollar on this basis.

In terms of price inflation, the UK has performed well in the last decade as a whole but in the last two years its inflation rate has risen relative to the US and euro area, though more so against the latter than the former, implying a lower pound. For productivity gains, the UK performance has been good against both economic areas but in the last two years it has also slipped back quite sharply, see chart b. In terms of short term and long term interest rates, the overall implication is that the exchange rate could fall further. Although there has been some volatility, charts c and d show that, particularly versus the euro, the fall in the pound is fully justified. The UK's usual interest rate premium against the euro has eroded, and what this implies in terms of a weaker currency is most vividly illustrated in chart e. Hence, the recent fall to record lows in sterling versus the euro should be no surprise, and indeed, if UK short term interest rates fall further relative to euro rates, then there could be fresh lows for the pound against the euro before too long.

...and these variables suggest that further falls are likely as UK interest rates are cut aggressively

Pulling all of these factors together in one indicator, see chart f, shows that after being in overvalued territory in the five years to mid 2007, the fall in the UK TWI has taken it back almost to where a composite index of the six key drivers of its value would suggest. Indeed, on this basis, the recent depreciation of sterling may be overdone, but if the expectations about the extent to which the MPC may cut interest rates and the budget deficit may widen are proved correct, then the recent market move is simply anticipating these shifts. However, if interest rates are cut more than expected, or price inflation does not fall back as projected in 2009, the pound could fall even further. On our calculations, the UK trade-weighted index could easily drop an additional 10 to 15%. Whatever the outcome, the foreign exchange markets seem to be showing that sterling is in for a bumpy ride in the year ahead.

Lloyds TSB Bank

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