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Economics Weekly

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How low can sterling go?

Tue, Nov 18 2008, 06:09 GMT
by Lloyds TSB Financial Markets Economic Research Team

Lloyds TSB Financial Markets

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.

...as 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.

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Published on  Tue, Nov 18 2008, 06:14 GMT