The dramatic slide in the value of the pound this year has raised plenty of questions. How does the latest fall compare with previous crisis periods? How much harder does exchange rate weakness make the Bank of England’s fight against elevated inflation? What’s next for the beleaguered currency?
Two distinct factors have weighed on the pound this year, writes Oliver Jones, asset allocation atrategist at Rathbones. The first has been the global strength of the dollar, which has benefitted from its status as the premier safe–haven currency, plus the relative resilience of the US compared with other major economies.
The dollar has risen strongly against most major currencies, gaining more than 10% against the Chinese renminbi, 15% against the euro and 20% against the Japanese yen so far in 2022. In both China and Japan, policymakers are sufficiently concerned that they’ve been intervening in foreign exchange markets.
The second factor, at the time of writing, has been UK-specific concerns about the previous direction of policy, especially around Former Chancellor Kwasi Kwarteng’s ‘fiscal event’. With inflation already too high and the Bank of England struggling to rein it in, the announcement of a substantial loosening of fiscal policy via the biggest tax cuts in nearly half a century was extremely hard to defend. Despite the government’s remarkable subsequent U-turn, the episode may leave lasting scars. The fact that fiscal policy has undergone such an enormous about-face within a month, and the political turmoil following, has only added to heightened uncertainty about the UK policy landscape further ahead.
That helps to explain why sterling weakened relative to the currencies of the UK’s trading partners generally, not just the dollar, this year (even though the extreme moves immediately after Kwarteng’s announcement have unwound). At its lows, it was down by slightly more than 10%, the fourth largest drop of the past three decades. That’s large, but not in the same league as previous crises — the declines of 19% after the UK left the ERM on Black Wednesday in 1992, 22% around the Brexit vote in 2016 and 30% during the global financial crisis.
An inflationary impact
Whatever the cause, the weaker pound has only added to the UK’s inflation problem. Falls in the currency typically increase the sterling prices of the goods and services that the UK imports. This was evident in the latest inflation figures, with food inflation, for example, rising to 14.5%.
The BoE has previously used the rule of thumb that a 1% fall in sterling (versus a weighted basket of the UK’s trading partners) ultimately increases consumer prices by nearly 0.3% over a three–year period. It estimates that the peak impact on inflation typically comes about a year later, when it is 0.1 percentage point (pp) higher than it would otherwise have been. A 10% fall in the currency would imply a 3% increase in consumer prices over three years, and inflation 1pp higher than it would otherwise have been in a year’s time.
But the rule of thumb is just that — the Bank acknowledges that in practice the actual effect may be much larger or smaller depending on the precise circumstances. There are many moving parts influencing inflation in the meantime.
Headline CPI inflation is 10.1%, and its high level is a product of more than just previous increases in energy prices. Wage growth is 6.0%, and the labour market is still extremely tight with unemployment the lowest in five decades. It’s also concerning that inflation expectations have been increasing recently.
The Citigroup/YouGov inflation tracker found households’ long–run expectations (five to 10 years ahead) rose above 4% in August and stayed there in September —well above the rate of around 3.5% that has prevailed for the past 15 years. Policymakers will want to avoid the possibility of lingering high inflation becoming entrenched in households’ and firms’ psychology and decision-making, which would add to the risks of it sticking around for much longer.
What next for sterling?
One can jump to conclusions about what will happen to the pound in the next few months, but confident predictions about its short–term direction should always be treated with plenty of scepticism. Forecasting currencies over short time periods is notoriously difficult.
There’s a lot of academic literature showing that reliably predicting exchange rates a year ahead is all but impossible. A host of models that have briefly appeared to fit the facts have failed to deliver good forecasts on a consistent basis. The basic problem is that, over short time horizons, currencies are far more volatile than justified by changes in economic fundamentals. So even forecasting the economy correctly (a hard enough task in its own right) isn’t enough to make accurate short–term currency forecasts.
Over longer time horizons, it’s possible to say more about the likely direction of exchange rates — but we need to take care. For example, the UK’s large current account deficit is often interpreted as an indication that sterling is likely to weaken in the long term. It’s widely assumed that large current account imbalances inevitably correct over time, with currency movements driving the adjustment. Yet in practice, models based on this assumption don’t have a great track record even when it comes to long–term forecasting.
As a recent paper published by the ECB has shown, so-called ‘behavioural equilibrium’ models have typically performed much better, and this is the approach we prefer. These models account for variables like the terms of trade (the ratio of prices of a country’s exports and its imports), relative productivity and demographics.
On this basis, sterling looks undervalued versus the dollar (though there’s generally much less of a difference compared with other currencies). In other words, we think that sterling is more likely to rise moderately than to fall against the dollar over the next five to 10 years, which is something we’re already factoring into our long-term decisions about where to invest.
This article was written for Portfolio Adviser by Rathbones’ asset allocation strategist Oliver Jones.