Quite A Pounding

14/10/2016 at 5:11 pm

At midnight last Thursday, the pound fell by more than 6% against the dollar. Its intraday (intranight?) low was 1.1841. Since then, cable has stabilized somewhat. It currently prices at about 1.22, up from a closing low of 1.2123 reached on Tuesday. So what does the pound’s latest “31-year low” – or even “168-year low” – signify, if anything?

First let us consider the very straightforward economic consequences, which are twofold.

On the positive side, the cost of buying British goods and services from abroad, from JCBs to tour bus tickets, falls. This is growth positive. It is also why currency devaluation is one of the most obvious and best understood forms of monetary easing.

On the negative side, the cost of buying foreign goods and services in Britain, from rice to Ritalin, increases. This is growth negative since it compresses margins for importers and makes consumers poorer. This is also why currency devaluation is a risky and unpredictable means of monetary easing.

One key question for the British economy is: which of these two effects will predominate? That depends purely on the inflationary impact. If this is relatively modest then devaluation will increase growth without hitting people’s pockets, or firms’ margins, too forcefully. If it is significant, however, then the devaluation will depress overall economic activity since domestic demand accounts for a far more substantial part of output than exports (62% versus 30% on Q2 GDP data).

It is hazardous to speculate as to which outcome Britain will face. On the one hand, supranationalist media sources are sure the export benefits will be slight and the inflationary impact severe. On the other, Brexiteering sources seem not to have considered the inflation question at all.

One thing we can do is examine the scale of the pound’s recent fall with some detached perspective.

Cable has fallen by 29% since the high of 1.7166 it reached in early July 2014. Its all-time closing low was posted on 26 February 1985 at 1.0520. However the pound has not yet broken through its December 2008 low against the euro (€1.025) or its more recent (2011) low against the yen. Looking at the Bank of England’s trade weighted index, which pits the pound against a basket of other currencies, this week’s low was barely through the previous record level reached in 2008 (73.3 versus 73.4 back then).

It is understandable that the focus of the media should be on the sterling exchange rate which has moved the most dramatically. However, again with some detachment we ought to observe that cable’s recent history has been affected by dollar strength as well as sterling weakness. The Federal Reserve’s trade weighted dollar index has risen by more than 21% since its 2014 low. Indeed, while the pound has fallen by 29% against the greenback the euro has not been far behind, dropping 21% since its own 2014 high point (from $1.39 to $1.10 today). Without wishing to overdo the point about press coverage one does not see headlines in The Economist about “votes of confidence” in the single currency.

Some sources have taken things further, with Bloomberg claiming that the pound has become an emerging market currency: “the new Mexican peso”. Now at the time of the “tequila crisis” back in 1994 the peso more than halved in value against the dollar in under three months. More recently, the Brazilian real almost halved in value as commodity markets collapsed in 2014-15. Again, a little more perspective would be nice.

This is not to downplay the risks arising from imported inflation. The UK’s next CPI and RPI prints will come out on Tuesday. PPI input prices in particular will merit close attention. Year on year they have already rocketed up from -15% to +8% in the space of 12 months. That inflation has to go somewhere: again, either into shrunken margins or consumer’s pockets (and if it persists, most likely both). Back in 2007, RPI inflation rose at around 4-5% and food prices were making tabloid headlines. Inflation also means higher pensions, higher gilt yields and higher public sector wages, all of which is bad news for Britain’s strained fiscal arithmetic.

Furthermore, Mark Carney today confirmed the Bank of England’s insouciant attitude to inflation at a “public roundtable”, saying that while he appreciated that it could cause problems he was willing to see the Bank miss its target to protect against the supposed loss of jobs into next year. (Readers of this blog will know that the MPC officially abandoned its founding mandate back in August). Markets are less complacent: expectations for a further cut in the base rate have evaporated, and the ten year gilt yield has risen to 1.1% from the record low of 0.52% it established only a couple of months ago.

Now price increases were back in the tabloids again just this week. If imported inflation does cause problems, and the Bank does nothing to stop it, then the ugly devaluation scenario may well end up playing out.  Looking at the bigger picture for sterling, and not just the cable rate, we ought not perhaps to panic overmuch. But even at a princely 1.1% the gilt market is not remotely priced either for an uncomfortable patch of price behaviour or the policy normalization required to deal with it. There could be some interesting developments ahead.

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