Sterling on the slide
The falling value of the pound will increase inflation Andrew Sentance
Sterling has been on the slide in 2016. The value of the pound has fallen by nearly 5pc against the currencies of our major trading partners since the turn of the year.
In the past week sterling has been hovering just above $1.40 and around €1.30. This is not especially weak against the euro – the pound was below €1.30 for nearly seven years from March 2008 until the end of 2014. But the value against the dollar is historically very low. There have been only three months in the past 30 years when sterling’s value against the US currency has averaged less than $1.42 – its average value on the foreign exchanges last week.
The most significant factor underpinning this recent slide against the dollar is the divergence in the outlook for interest rates on the two sides of the Atlantic. In the summer and early autumn, the pound was trading around $1.55 and the expectation in financial markets was that UK and US interest would both rise around the turn of the year. The Fed was preparing for its first postcrisis rate rise, which was ultimately delivered in December. Mark Carney had also talked in July of the Bank of England considering a rate rise “around the turn of the year”.
Following the publication of the Bank of England’s November Inflation Report, however, it became clear that the “turn of the year” which Governor Carney was talking about was not end2015, but more likely end-2016. In his speech last week, he confirmed that he is in no hurry to raise UK interest rates, despite the Fed’s rise in December. The pound has lost nearly 10pc of its value against the dollar as markets have adjusted to the latest shift in UK interest rate policy.
The recent downward move of sterling against the euro is less to do with interest rates and more likely reflects improving economic prospects in the rest of Europe – as I highlighted a few weeks ago in this column. In 2014, the UK was the leading economy for growth in the G7, with our economy expanding by 2.9pc. Growth in the eurozone that year was just 0.9pc – less than a third of the UK growth rate.
The most recent figures show that this gap in GDP growth has narrowed from two percentage points to just half a percentage point: 2.1pc UK growth in the past year, compared with 1.6pc in the eurozone. The UK’s growth performance now stands out less prominently among the European economies and the value of our currency has adjusted downwards to reflect that.
Forecasting exchange rates is a hazardous business, but until the Bank of England has a change of heart on interest rates, I would expect sterling to remain close to its historic lows against the dollar.
It is hard to see it climbing much against the euro either. In fact, there could be a further downward shift in the pound if uncertainty about the outcome of the EU referendum starts to have an influence on our currency later this year.
So, if a relatively weak pound prevails for much of this year, what does it mean for our economy and personal finances?
Manufacturers will breathe a sigh of relief, and a more competitive pound can provide some support to the part of the economy which is most under pressure at the moment.
Manufacturing output and employment has been falling this year – as we have seen in the recent headlines about job losses in the steel industry. However, we need to be wary about expecting too much of a boost to industry from a weaker pound. Our key exports – like the car industry, which reported record overseas sales last year – are not very price sensitive. UK goods sell mainly on quality, brand and technology. Being more price-competitive can help at the margin, but it is not the over-riding factor driving our exports.
Consumers, by contrast, will find that a weak pound is not to their advantage. The weakness of sterling in the aftermath of the global financial crisis added to UK inflation by pushing up the cost of imported food, energy and manufactured products. In late 2011, UK inflation peaked at over 5pc and the resulting squeeze on consumer spending power held back the recovery.
We should not see such a strong surge in inflation this year, because low oil and food prices have pushed inflation very close to zero. But a weak pound makes it more likely that inflation will rise over the next 12 months, and a rebound in the oil price could reinforce the upward pressures. In my view, headline inflation is likely to end 2016 much closer to 2pc than to the current rate of 0.2pc.
Holidaymakers will also feel the impact of a weaker currency. If the pound remains around 10pc below its value last summer, it will buy less in key holiday destinations. The US is likely to feel quite expensive at $1.40 to the pound. Travellers will find better value in destinations with weaker currencies – such as Australia, Canada, South Africa and Brazil. The flip side of this, however, is that the UK is going to appear quite attractive for Americans.
For the economy as a whole, this is likely to be a process of swings and roundabouts. Manufacturers will be helped a bit – while consumers will be squeezed as inflation rises. Growth in the UK economy of just over 2pc is still on the cards, with unemployment continuing to fall – as we saw in the latest figures.
The UK economy can cope with the recent decline in sterling and the recovery will continue. We have learned to live with swings in the value of our currency. Since 2000, sterling has fluctuated between below $1.40 and over $2. It has been below €1.10 and over €1.70.
But the current weakness of the pound against the dollar is the price we are paying for delaying interest rate rises here in the UK. And it will take the edge off the benefit we might expect from the recent fall in oil prices. By the end of this year, zero inflation is likely to be a distant memory.
‘Since 2000, sterling has fluctuated between $1.40 and over $2. It has been below €1.10 and over €1.70’