year high of 1 per cent — even before any notable impact from the fall in the pound. Some analysts estimate it could hit 4 per cent by 2018, which is double the Bank of England’s target.
For Jane Foley, chief currency strategist at Rabobank International, the government is less likely to be concerned about the absolute value in the pound — unless truly calamitous — but rather continued volatility in the currency. That would make it more difficult for companies to plan ahead.
“High levels of volatility can have a detrimental impact to the economy,” Foley said. “In some instances the size of a currency’s movement may have greater relevance to policymakers than its actual value.”
The pound’s drop is evoking memories of one of the most defining moments in post-war Britain, when in 1976 the then Labour government had to approach the International Monetary Fund for a loan after the currency fell by a quarter to a then record low against the dollar.
In return for the loan — at US$3.9 billion, it was the largest the IMF had ever made — the government had to change economic policies and cut spending and clamp down on wages. The prescription is the same as what Greece is being forced to do today.
The episode trashed Labour’s reputation for economic competence and fostered the rise of the free-market ideology and the rise to power in 1979 of Margaret Thatcher’s Conservative Party. But the Conservatives also saw their reputation for economic competence damaged
when in 1992 the pound was ejected from a fixed European exchange rate system that was the precursor to the euro.
One mitigating factor today is that Britain’s economy appears on the whole more able to withstand a similar drop in the pound. In 1976, for example, the price of oil had recently quadrupled, sending inflation to around 25 per cent. Interest rates soared to 15 per cent, compared to near zero today.
If the pound does drop more sharply, the Bank of England could be the first responder in any attempt to stabilise it.
BNY Mellon’s Derrick doubts the government would request that the central bank intervene directly in the currency markets to prop up the pound by buying it and selling other currencies. That’s partly because the country’s foreign exchange reserves wouldn’t last for very long in today’s multi-trillion foreign exchange market.
But the Bank of England, which is independent from government on setting interest rates, could look to tighten monetary policy, such as by raising interest rates, if it becomes concerns about inflation rising. That would likely support the pound — higher rates tend to bolster a currency.
There’s a catch. Higher rates would also further hurt the economy and put pressure on households by making mortgages more expensive.
So while the pound’s drop is unlikely to push the government to back away from Brexit altogether, it could make it harder for it to ignore the economic pain of breaking cleanly from the EU single market.
“The main challenges (to Brexit) today are coming from the financial markets,” said Professor Iain Begg of the London School of Economics.