Sterling is sharply weaker not only relative to the euro but even relative to the US dollar. Why is this, what are its consequences and is there more to come? The questions are clear. The answers will be less so.
Economists are rubbish at predicting or understanding exchange rate movements. As an external member of the Bank of England’s monetary policy committee during its infancy and toddler years, 1997-2000, I first tried to predict exchange rate movements based on the received academic orthodoxy of intertemporal multi-currency asset pricing models and their pedestrian counterparts, uncovered interest parity, with or without time-varying currency risk premiums. These approaches were useless. I “progressed” to ad hoc exchange rate models based on assorted portfolio balance considerations, carry trade add-ons and error-correction fixes. They too turned out to be useless. I ended up reverting to the practical man’s version of Meese-Rogoff (“the best predictor of tomorrow’s exchange rate is today’s exchange rate”), assuming the exchange rate would be constant. Basically, I ended up treating sterling’s exchange rate like a rogue elephant: I recognised its power and unpredictability, respected it, even feared it, but did not treat it as something amenable to guidance and direction by the BoE.
Nevertheless, we can try to make sense of the recent weakening of sterling by considering both the fundamentals and the fuzz.
First the fundamentals.
The UK economy is slowing. It is indeed likely to slow down more than most of its competitors, with the possible exception of the US. The euro area, while affected by the north Atlantic financial crunch, is likely to be on course for 2 per cent growth in 2008. The growth of the UK economy is likely to decelerate from an annual rate of more than 3 per cent in the third quarter of 2007 to a rate somewhat below 2 per cent by the end of 2008. Risks are skewed to the downside. US growth will also moderate quite significantly but, thanks to the continued weakness of the dollar, US exporting and import-competing sectors are taking full advantage of a still robust global growth environment. The US trade deficit is narrowing, offsetting the contractionary impulses from its imploding residential construction sector.
The UK is lagging well behind the US in substitution of external demand for domestic demand. The recent weakness and likely future weakening of sterling’s real effective exchange rate will benefit domestic producers only later in 2008 and beyond. In the meantime, the UK’s external deficit is looking like that of the US before mid-2007. The UK current account deficit is close to 6 per cent of gross domestic product, with the private sector financial deficit (mainly the household sector) contributing 3 per cent and the public sector deficit almost 3 per cent.
It is helpful that the private sector is wielding the automatic stabilisers. It would be even more helpful if the public sector could counter the slowdown through an appropriate countercyclical increase in borrowing. Unfortunately, the pro-cyclical behaviour of the public finances during at least the past four years pretty much emasculates even the automatic fiscal stabilisers if the government does not wish to violate its fiscal norms, especially the sustainable investment rule (net public debt less than 40 per cent of annual GDP), but possibly also the (much-fiddled) golden rule (over the cycle, borrow only for public sector investment).
Despite legitimate concerns about elevated inflation expectations, UK inflation is less of a threat than inflation in the eurozone, the US or key emerging markets. Consequently, UK official policy rates are likely to come down this year relative to those in the euro area and most emerging markets. The US Federal Reserve may cut rates as much as the BoE, despite stronger underlying inflationary pressures in the US, because unlike the BoE and the European Central Bank, the Fed is not a hierarchical or lexicographic inflation targeter. The Fed trades off inflation for unemployment when it believes such a trade-off exists, which is pretty much all the time – the Fed always lives in the short run when expectations are given and wage and price contracts pre-determined. It is the classic opportunistic captive in the monetary policy game without credible commitment. The Fed consequently is more inflation-tolerant than both the BoE and the ECB.
These fundamentals all call for a further weakening of sterling, certainly relative to the euro and possibly even relative to the US dollar.
In addition there are market fears, palpitations and hysterics. The BoE has lost kudos since August because of the way it mishandled the liquidity crisis in the sterling interbank market. The UK Treasury and the regulator, the Financial Services Authority, fumbled Northern Rock. Except for the US Treasury, which promoted some ineffective/abortive initiatives, no other treasury or regulator has been tested yet. It is hard to quantify what the resulting market jitteriness is worth in terms of the effective exchange rate of sterling, but it clearly is a negative.
A bit of excessive weakness for sterling, as a result of the market’s recalibration of its judgment of the relative competence of the central banks that matter, may well help the UK economy in the short run. A confidence-driven decline of sterling on top of weakness warranted by the fundamentals may be just what the economy needs, now that fiscal remedies are unavailable.