Mixed blessing
What now for surging pound? Ambrose Evanspritchard
Sterling has rocketed against the US dollar in the biggest two-day rise since the referendum as war drums beat louder at the Bank of England, catching speculators badly off guard. The pound surged to a 15-month high of $1.36 after the Monetary Policy Committee’s leading dove backed the push for monetary tightening, citing incipient wage inflation and signs that the post-crisis phase of debt deleveraging has run its course.
“The amount of economic slack continues to be eroded,” said Gertjan Vlieghe, a hedge fund economist who joined the voting body in 2015. “We are approaching the moment when Bank Rate may need to rise, may be as early as the coming months.”
The shift by Mr Vlieghe has electrified markets since he has long argued that the dangers of raising rates too soon outweigh the risks of waiting too long. “This is highly significant,” said David Owen from Jefferies.
“It looks as if the whole MPC is now behind a rate rise. The markets didn’t seem to get until now that the mood music on monetary policy in the UK has moved on,” he said.
The chorus of hawkish noises from Threadneedle Street has sent the pound smashing through key levels of resistance on the exchange markets, forcing sterling bears to cover “short” positions. Over the last three weeks it has risen 6pc against the dollar, and 5pc against the euro and yuan.
It is an open question whether the rally is sustainable as Brexit talks darken and investment is delayed. “Over the next two to three years sterling is going to adjust to macrofundamentals. We think the pound may need to fall even further to reach an ‘equilibrium exchange rate’,” said Mr Owen
David Bloom, from HSBC, said it is nigh impossible for markets to make a sensible judgment on sterling until the terms of Brexit are clarified. The outcome is starkly binary given the possibility of acrimonious rupture. “Everybody knows that the pound is mispriced at the moment. It is either much too strong or much too weak,” he said.
The International Monetary Fund says the UK’S real effective exchange rate (REER) was badly overvalued at the peak in late 2015.
It is a key reason why the current account deficit ballooned to a post-war high of 6pc of GDP, although the picture was distorted by a temporary fall in investment income from the crisis-wracked eurozone. The exchange rate needed to weaken, Brexit or no Brexit. The country was covering consumption with capital inflows.
The devaluation does squeeze real incomes by raising the cost of imports but it makes it easier for the Bank of England to break out of the deflation trap and start to normalise interest rates. Central banks in Japan and Europe have yet to do so and may face a quandary if the next global downturn hits soon.
Less clear is whether sterling’s 17pc slide in trade-weighted terms since early 2015 will spur exports – with a “J-curve” delay – and improve the trade deficit. Data for the second quarter will offer crucial clues. The big devaluation in 1992 worked like a charm but that was because the UK had been freed from the distortions of the Exchange Rate Mechanism. “It was straightforward. There were no other complicating factors and Britain was not leaving the EU. We are in a different world today.” said Simon Derrick from BNY Mellon.
The sterling plunge in 2007 after the collapse of Northern Rock is a study in contrast. It acted as a shockabsorber but it did not do much to improve the current account deficit. That was because the collapse in world trade made it harder for the UK to export its way out of trouble, and the eurozone’s austerity-induced crash from 2011 to 2013 made matters worse.
This time world trade is recovering and Europe is booming again. The circumstances are more benign (for now) yet the lift from trade has so far been disappointing. Analysis from the Office for National Statistics shows that goods exporters have used up three quarters of the devaluation gain by boosting prices and margins, often because their own import costs have gone up. Only a quarter of the effect has been used to boost market share. Service sector exports have a low sensitivity to the exchange rate.
There are, of course, subtle effects on import substitution that are not picked up in the data. We know that a fall in sterling has helped to save a UK steel industry on the brink, and the same goes for a host of manufacturing firms that were hanging on precariously two years ago.
A weaker sterling has prevented a slump in UK commercial property by drawing in foreign buyers looking for bargains, and therefore averted a contractionary shock caused through use of real estate as a collateral for business borrowing.
“We will never know the counterfactual, but it is fair to say that if the pound had stayed where it was, Britain would be in recession right now,” said Mr Owen.
So let us keep our fingers crossed that sterling does not rise any further this autumn.