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Economics Weekly - Why is the pound depreciating so rapidly, so suddenly? Weekly economic data preview - BoE MPC minutes and UK Q4 gdp in focus

Economics Weekly 21 January 2008


Why is the pound depreciating so rapidly, so suddenly?


Is the recent period of sterling strength over?

After being very strong for the last few years, the UK pound is suddenly weakening, see chart a. It has fallen sharply against the US$ and reached an historic low of 0.7614 against the euro. There are some important questions to be asked about this recent slide in the value of sterling in trade-weighted terms, down 10% in the last six months, not least what it may mean for UK monetary policy. But before asking that question, it seems pertinent to analyse why the pound has started to depreciate now and why not last year or some other time. The reason for this approach is that understanding some of the factors behind the fall may help explain the level that the pound could reach and this will be important in determining its impact on policy.


Market view is primarily based on interest rate differentials…

We can start with the market view – that currency moves are driven by differences in interest rates and interest rate expectations. Chart b and c shows that this view is not always right, though it sometimes is, usually in the short term. Using the US in this example, and taking the difference between 3 month cash rates and 10 year bond yields, shows that the current weakness in the bilateral exchange rate cannot be explained only by interest rate differentials. Chart d and e shows this to be especially true using euro short-term interest rates because the UK still enjoys a substantial yield gap with the euro area, though admittedly not as large as a year ago.


...but this is not the main reason for the decline…

So what other explanations are there for sterling’s decline, if not interest rate differentials? There is the argument that the UK is no longer an oil exporter so has lost its ‘petro-currency’ status and that the fall in oil production is responsible. But was there ever an association between sterling and oil prices? The chart overleaf would suggest not a sustainable one. Sterling has been strong even when oil prices have been weak and vice versa. This does not suggest much of a directional or casual link. But even if there were a link between the sterling TWI and oil, it is likely that the TWI would now fall even with a strong oil price as UK oil production drops back.


…other reasons like the widening trade deficit explain its decline…

We believe the real reason for the fall in the UK TWI lies in the widening of the external or current account deficit, which had been largely ignored by financial markets until now. To see if this is so, we construct an equation that explains the fall in the exchange rate using the UK current account deficit, interest rate differentials and oil prices to see which exerts the most influence. The results show that it is the current account deficit that is most responsible for the direction of the pound’s trade weighted index in the long run.


This is important; as the main reason for the slide in the current account deficit is that the UK economy has been growing faster than its major trading partners in recent years. This is shown by running an equation that uses the trade weighted index and the relative growth rate of the UK with its major trading partners to explain the UK's external deficit. The equation shows that the single biggest influence on the size of the deficit, as a share of gdp, is relative growth in demand between the UK and the countries it trades most with. In other words, it is not currency appreciation that has led to the wider trade deficit but too fast growth in the UK economy in recent years.


…and they suggest that it could fall another 10%, limiting the scope for rate cuts this year

Slower UK economic growth should therefore eventually narrow the deficit and so stem the slide in the trade weighted index. But what levels does this imply for the TWI? Using our model of the TWI, and putting in our forecast for oil prices, the trade deficit and interest rate differentials, the TWI falls to 85.3 over 2 years, some 12% below current levels. Such a move in the TWI will have implications for any interest rate cuts in the months ahead, as the falling TWI will heighten the effects of higher global oil and food prices on UK CPI inflation, which is already a bit above the 2% target. Effectively, the MPC may lose inflation credibility, if it cuts rates even though CPI inflation rises further above its target , as seems likely in the months ahead. However, the MPC may still trim interest rates because wage inflation is still low but we predict that Bank rate will not fall as much as financial markets are currently expecting.


Trevor Williams, Chief Economist


Weekly economic data preview W/c 21 January 2008


BoE MPC minutes and UK Q4 gdp in focus


The minutes of the January BoE MPC meeting will take centre stage in the UK this week and could test market confidence about the likelihood of a cut in base rates in February. The preliminary release of UK Q4 gdp is also due and will be analysed to see to what extent economic activity was dampened by a sustained higher level of interestrates. A very quiet calendar for US data and Fed speakers will keep the focus on the upcoming Fed meeting on January 29/30th and on Washington where the US administration is considering its options to support the economy with lower taxes. Four central bank rate decisions are scheduled this week, but interest rates are only expected to change in Canada where we expect a cut to 4.0%. Business confidence indicators and the German IFO are due in the euro zone.


• A speech by Bank of England (BoE) governor Mervyn King on Tuesday could help shape interest rate expectations ahead of the release of Q4 gdp and January MPC minutes on Wednesday. MPC deputy governor Gieve struck a mildly dovish tone on the economy and interest rates last week, suggesting he was perhaps one of the policymakers who voted for lower rates this month. It will be interesting to see to what extent the governor shares Mr Gieve's thought that 'economic growth has started to slow sharply now'. The governor may share his own view of the threats facing the economy and the priorities discussed by the MPC two weeks ago. We expect the minutes to reveal that at least two committee members voted for a 25bp rate cut in January. One of the answers markets will be looking for is whether the MPC discussed cutting rates for a second consecutive month, and to what extent it resisted a move because of inflation and worries of second round effects. This could be crucial in understanding the bank's willingness to lower rates in the coming months as the economy slows. Even though worries have intensified that price pressures could be more sustained due to the depreciation of sterling, falling unemployment and higher utility bills, the reports last week of stable CPI inflation and average earnings growth showed no further deterioration of the inflation landscape. The preliminary Q4 gdp data will be released simultaneously with the MPC minutes on Wednesday and will give a first account of the economy's performance, and resilience, in the face of the tightening in money market rates and faltering consumer confidence. Our forecast is for a slowdown in gdp growth to 0.6% q/q and 2.9 % y/y. This would mark the lowest figure since Q3 2006. The possibility of a decline to 0.5% q/q growth cannot be dismissed given the slowdown in output growth in the services sector, weaker household consumption and the widening tendency of the trade deficit.


• An exceptionally quiet week in the US features the release of weekly initial claims and existing home sales on Thursday. Financial markets are closed on Monday to observe Martin Luther King Day. Worries that US economic growth is slowing more rapidly than previously anticipated intensified last week after negative reports on retail sales, housing construction and the biggest decline in the Philadelphia Fed index since 2001. This will leave markets mulling over policy responses by the Fed and the US administration. Monetary policy and lower interest rates alone are no longer considered as the only viable solution to help the economy overcome the housing market turbulence. The benefits of a comprehensive fiscal stimulus package were discussed during Fed chairman's Bernanke testimony to Congress last week. More specific details about corporate and income tax cuts, reported last Friday to be worth around 1% of gdp or $145bn, may emerge this week as president Bush prepares for his state of the union speech on January 28th.


• In the euro zone, the flash PMI's for January on Wednesday and the German IFO survey on Thursday will be released and could make a significant impact on perceptions of future ECB policy. Confidence may be tested that the euro zone economy can withstand the US slowdown and that stronger domestic demand has made euro zone growth more entrenched. The PMI's and the IFO data will also be judged in the light of conflicting messages from ECB members last week which did no good to the bank's transparency and also questioned the bank's official position that it can still raise interest rates pre-emptively to offset upside inflation risks from wages.


Kenneth Broux, Economist


Economic Research,

Lloyds TSB Corporate


10 Gresham Street,

London EC2V 7AE,


0207 626 - 1500


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