Forex Blog - Economics Weekly - How low can sterling go? Weekly economic data preview - BoE & Fed minutes due as expectations of further rate cuts rise
Economics Weekly 17 November 2008
How low can sterling
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
...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 UKâ€™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 UKâ€™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.
In terms of price
inflation, the UK has performed well in the last decade as a whole but in the
last two years its inflation rate has risen relative to the US and euro area,
though more so against the latter than the former, implying a lower pound. For
productivity gains, the UK performance has been good against both economic areas
but in the last two years it has also slipped back quite sharply, see chart b.
In terms of short term and long term interest rates, the overall implication is
that the exchange rate could fall further. Although there has been some
volatility, charts c and d show that, particularly versus the euro, the fall in
the pound is fully justified. The UKâ€™s usual interest rate
premium against the euro has eroded, and what this implies in terms of a weaker
currency is most vividly illustrated in chart e. Hence, the recent fall to
record lows in sterling versus the euro should be no surprise, and indeed, if UK short term interest
rates fall further relative to euro rates, then there could be fresh lows for
the pound against the euro before too long.
...and these variables
suggest that further falls are likely as UK interest rates are cut aggressively
Pulling all of these
factors together in one indicator, see chart f, shows that after being in
overvalued territory in the five years to mid 2007, the fall in the UK TWI has
taken it back almost to where a composite index of the six key drivers of its
value would suggest. Indeed, on this basis, the recent depreciation of sterling
may be overdone, but if the expectations about the extent to which the MPC may
cut interest rates and the budget deficit may widen are proved correct, then
the recent market move is simply anticipating these shifts. However, if interest
rates are cut more than expected, or price inflation does not fall back as
projected in 2009, the pound could fall even further. On our calculations, the UK trade-weighted index
could easily drop an additional 10 to 15%. Whatever the outcome, the foreign
exchange markets seem to be showing that sterling is in for a bumpy ride in the
BoE & Fed minutes
due as expectations of further rate cuts rise
The minutes of the BoE
and the US Fed's last interest
rate setting meetings are published on Wednesday. Both are likely to show
strong support for the last round of interest rate cuts, given the worsening
global economic backdrop and the growing possibility that inflation may drop
sharply, undershooting targets. Last week's BoE November quarterly inflation report
showed a significant downward revision to the UK inflation outlook,
predicated on lower commodity prices and weak domestic demand. The BoE now
seems to take the view that the economy will join the eurozone in technical recession
this year, as it emphasised the likelihood of another contraction in Q4 and a
1.5% decline next year before recovery in 2010. Although the last 1.5
percentage point interest rate cut and the heightened possibility of another
one percentage point cut to 2% in by the end of the year should deliver a
strong economic stimulus, continuing problems in inter-bank and credit markets
and job insecurity and unemployment rising mean a more prolonged recession may
now be likely, even with coordinated fiscal initiatives. In the Eurozone, the
initial Q3 GDP result showed a 0.2% contraction. EU-15 data this week may show
a very weak set of manufacturing & service sector surveys for November,
increasing the possibility of another output contraction in Q4. Recession in
the major economies will trigger a sharp drop in consumer inflation, which
gives justification for further interest rate cuts. The BoJ is expected to keep
interest rates on hold at 0.3% at its meeting on Friday, having made its first
cut in seven years last month.
â€¢ The BoE minutes from
the 5/6 November MPC meeting due on Wednesday are likely to show unanimous support
for the large cut in rates and a very bearish discussion on growth and
inflation. In some ways, the minutes have been superseded by last week'
quarterly inflation report, but the details of discussions will still attract
considerable interest. UK data this week include
CPI inflation, which could fall to 4.7% in October from 5.2% in September. This
will mark the start of a sharp downward trend as lower food & energy prices
and weak high street sales dampen the index. The UK also publishes retail
sales data for October - anecdotal reports suggest that monthly sales may fall by
1%, bringing the annual rate to 1.3%, close to the low of 0.6% annual growth in
September 2005. Public finance data may show the PSNB YTD cumulative balance
rising further from Â£37.6bn in September, the highest 6-month shortfall since
1946-7 and up from Â£21.5bn a year earlier. Clearly not a good place from which
to embark on emergency fiscal spending. However, extraordinary measures will be
enacted on 24th November (publication of the Pre-Budget Report) to boost the
â€¢ There may be no
surprises in the minutes of the Fed's 28/29 October FOMC meeting - the
discussion is likely to have focused on downside risks to growth, keeping open
the possibility of another cut in official interest rates by year-end. US data releases are
likely to show that producer and consumer prices decreased in October,
following reductions in key commodity prices. Capacity utilisation is also
important as it could fall close to the 75% level which may indicate that the
recent acceleration in jobs losses could be stepped up. Clearly, should job
insecurity continue to contribute to weak consumer spending, the government's
task of getting the US economy moving again
will become an even more difficult one. Both the Empire Manufacturing and the
Philadelphia Fed surveys for November are expected to show a worsening business
outlook. Neither is the housing market situation improving as housing starts
and building permits are expected to have decreased in October.
â€¢ This is a quiet week
for eurozone data as initial Q3 GDP and final October CPI inflation were
published last week. The PMI manufacturing and services surveys for November
are due, however, and could come in below the October lows of 41.1 and 45.8,
respectively. Given the disparity in Q3 GDP results between member countries,
the PMI regional breakdown will provide some indication of whether German PMIs
also under-perform the EU-15 average.
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