Sterling: A View

October 16, 2016

The fall in the pound to date is good news for the economy. If this were to develop into a sterling crisis, however, it would become a problem for us all.

It is necessary to recognise the benefits of the pound’s depreciation, but it is also important to keep this in context, and not to overreact. That said, we must appreciate the challenges that could possibly lie ahead, too.

There are measures the authorities could take to guard against a sterling crisis. The most important of these are to ensure that there is no apparent conflict between the Chancellor and the Prime Minister, and to provide policy clarity on what lies ahead. Although comments made regarding the Government’s approach towards leaving the EU were the trigger for the latest downward move in sterling over recent weeks, it would be wrong to attribute this currency adjustment solely to Brexit.

To understand why the initial move down in sterling is welcome news for the economy, it is necessary to see this in the context of rebalancing the economy. In the wake of the 2008 financial crisis, it was widely accepted by economists and politicians that the economy needed to rebalance. This was defined in different ways, but it included recognition of the UK’s twin deficit problem: the budget deficit, and the current account deficit. The former has improved slowly. The latter has continued to deteriorate — so much so, it now stands at over seven per cent of GDP, leaving the UK dependent upon foreign inflows. The Governor of the Bank of England has referred to this as the ‘kindness of strangers’. Regardless of the referendum, this would have taken its toll on sterling at some stage. Indeed, the economy needs to rebalance.

In recent years, sterling has been viewed as overvalued. For instance, during the summer of 2014, the International Monetary Fund, among others, was warning that a lack of export diversification was among the factors contributing to sterling’s overvaluation. And, as former Governor Mervyn King acknowledged last week, the idea of rebalancing the economy, when he was at the Bank of England, included a weaker pound. That made sense then and still does now.

Moreover, in a global environment where economic growth is modest and trade weak, and, in a domestic environment where inflation is low and continues to undershoot the Government’s two per cent target significantly, a weaker pound can be viewed in a positive economic light.

Sterling has acted as an important shock absorber for the economy. This is in contrast to the Eurozone, where fixed currencies force economic adjustment on to other so-called ‘real’ economic variables, such as jobs. Sterling lost around one quarter of its value in the wake of the 2008 crisis, before eventually stabilising. Later, between 2013 and 2015, it strengthened, including against the euro. Of course, there are both winners and losers when currencies adjust, and the overall impact takes time to feed through fully. For instance, following the 2008 depreciation, there was a subsequent rise in input costs, which contributed to a squeeze on real incomes, as wages were not rising strongly.

The Bank of England calculates that just under two thirds of the effect of a currency fall feeds through into input prices. Even then, the extent to which this feeds through into domestic prices depends upon other factors, including margins and demand. In recent years, corporate profit margins have increased, and the outlook for demand has been uncertain. These factors may limit the final inflation effect of this currency fall, as margins are squeezed, and firms seek efficiencies, and limit price rises to maintain market share. For instance, the quarterly Inflation Report shows corporate profits (outside the oil sector) above 18 per cent — this is high; when sterling weakened after the financial crisis, such profits fell from just under 18 to around 14 per cent.

Inflation expectations and wages matter, too, helping to determine the extent to which any increase in costs can be passed through on to the high street. We must recognise that domestic cost pressures are subdued. All that being said, inflation will rise. It was already expected to do so prior to this depreciation, as falls in energy prices fell out of the annual comparison, last year. To compound all this, oil prices have now risen in dollar terms, following the recent OPEC output cuts. So, over the next year there is likely to be a one-off rise in inflation, which we would then expect to be reversed.

Thus, I would agree with the comments Governor Carney made in Nottingham last Friday that he would be prepared to tolerate a temporary overshoot of the inflation target. How living standards are impacted by this will depend upon jobs and wages.

While it is vital to take seriously the impact of policy on employment and living standards, we must also appreciate the potential benefits of a weaker pound in helping rebalance the economy. Also, we should recognise that, in time, a rebalanced and stronger economy will see the pound appreciate. But what about now?

What should be done?

This is not yet a sterling crisis. There is no hard and fast rule as to what constitutes a sterling crisis, but we tend to know one when we see it. In such a crisis, a currency falls sharply and uncontrollably. It can then also force domestic policy to take a different path to that which is needed on domestic economic grounds. Usually, this is a restrictive path, with higher rates and tighter fiscal policy. In essence, in a sterling crisis, the markets call the shots. We are not in this situation.

A perceived policy of benign neglect towards the currency is never good, particularly in the current circumstances. So that must be avoided.

Recognising the limitations of what can be achieved is also necessary. It is hard to stop a currency depreciating if it is under attack, but not impossible. In the past, the Bank of England would conduct a ‘bear squeeze’ if they thought the currency was being oversold and driven down by speculators. This is always an option, but needs to be carefully judged: you don’t want a red rag to a bull to incentivise the markets to take you on.

Alternatively, you could just bear it. The economic fundamentals have been good following the referendum, and the UK is now even more attractive for inward investment. At some stage, the expectation will be that sterling is seen as oversold and represents good value. This is the likely approach that will be taken. But, even if it is, it needs to be supported by policy and policy announcements.

The likely squeeze on real incomes should be seen as temporary, and should reinvigorate the Government to follow through on the other areas of its economic policy: namely, boosting domestic demand, and focusing on infrastructure, productivity, and keeping taxes low. Controlling unskilled migration, and an effective regional policy, will take time to feed through. Although such measures may not directly address the current currency issue, they do matter — as, indirectly, they will help to restore investor and market confidence that the Government is on the right course.

There must not be seen to be disagreement between the Chancellor and others, over policy. This is particularly so regarding Brexit — rightly or wrongly, this is a matter of perception; the misreading by the market needs to be addressed. Also, public disagreement between the Governor and Government is best avoided, feeding unnecessary uncertainty.

But the real challenge is this: what if the markets now see the currency as the way to take on the core of the Government’s strategy, and force a change? That leads directly on to the issue of Brexit policy and the Single Market. For some firms, as we are hearing, the current status quo makes sense. But the Government needs to look at this from an economy-wide perspective, and thus weigh up the pros and cons of the Single Market. It seems to me that all too often we overstate the pros, and do not spend enough time reflecting on the cons of the Single Market, and the opportunities that could arise from a change. The Referendum vote now allows us that opportunity.

Being in the Single Market may not be in the best long-term economic interests of the UK. It is the Single Market issue that appears to have become to the latest stage of this currency move.

It needs to be made clear that the policy the Government is taking towards the EU is not only driven by sovereignty and migration, but that it is also economically motivated. It needs to be clear that the best economic policy for the UK is for it to be global, and to have access to — but not membership of — the Single Market. The importance — and economic benefits — of a ‘clean’ Brexit, combined with a bespoke UK-EU deal that addresses current market concerns, needs to be clarified.

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