Sunday, November 20, 2005
Sterling could be a sitting duck
Posted by David Smith at 11:00 AM
Category: David Smith's other articles

Something rather unusual is about to happen if the markets are reading the runes correctly. Interest rates in Britain are not going to rise any time soon and probably have further to fall.

Interest rates in America, in contrast, have further to rise, giving us our unusual event. Sometime in the next few months US rates will climb above those in Britain. Official rates in America, which not so long ago were 1%, will soon be higher than here. And, while such an event comes round more frequently than Halley’s comet, it is indeed very rare.

Last week Mervyn King presented the Bank of England’s new quarterly inflation report. In August, when the previous report was published, interest rates had just been cut but the tone of the Bank’s document and the governor’s comments were hawkish. About a week later we discovered why; he and three of his colleagues had opposed cutting rates.

This time it was different. While the Bank is upbeat (probably much too upbeat) about the economy’s growth prospects next year, it is relaxed about inflation. The new forecast is that if interest rates stay at 4.5% inflation will exactly hit the 2% target in two years’ time, and spent much of the intervening period below it.

True, central bankers are never entirely relaxed about inflation. One concern expressed by King was that higher energy prices could yet feed through to high wage settlements.

That, however, does not look very likely. The clutch of economic figures produced last week pointed in the same direction. Consumer price inflation was down, from 2.5% to 2.3%, and so was retail price inflation, more important for pay negotiations, from 2.7% to 2.5%.

Both measures of producer price inflation fell, output price inflation dropping from 3.3% to 2.6%, that for input prices from 10.2% to 7.7%.

The common factor in these figures was oil. It was never likely that crude prices would stay long at $70 a barrel, as I wrote at the time. We are heading down to a sustainable, sub-$40 a barrel level for oil prices. It won’t necessarily be smooth but it will happen.

Meanwhile, those wages some at the Bank fret about are behaving impeccably. Earnings growth in the 12 months to September was just 3.7%. Underlying earnings growth was only 4% in the latest three months.

The labour market conundrum I wrote about recently is working to hold down wages growth. Claimant unemployment continues to rise, up by 12,100 last month, as it has done throughout this year. But employment continues strong. Companies are choosing migrant workers from the new EU member states in eastern Europe, or others new to the workforce, in preference to the exisiting unemployed. The effect of this job market competition is to hold down pay growth.

So there is nothing in the figures which argues the next move in UK interest rates should be up. In America, however, both the statistics and the language are different. America’s core inflation rate edged higher last month, and its headline rate remains above 4%.

Meanwhile Ben Bernanke, the man who is about to step into Alan Greenspan’s shoes as Federal Reserve chairman, signalled his enthusiasm for UK-style inflation targeting but also insisted he would stick with the great man’s monetary policy, that of a further “measured” increase in interest rates.

On some forecasts America’s Fed Funds rate won’t stop climbing until it hits 5%, while the Bank’s base or “repo” rate will not stop falling before it gets ot 4%. Even shading those numbers back to 4.75% and 4.25% respectively, which is more or less the consensus view, a gap opens up in favour of higher American rates.

What would be the implications of this? In most respects it looks perfectly logical. The US economy has stronger growth and higher inflation than Britain, so why not interest rates that are higher than here?

The fact that this happens so rarely, however, and does not last for very long, makes some people nervous. When America last had higher rates, during 2000 and early in 2001, the pound’s average value was much lower than at present. Instead of the low $1.70s, it was typically in the $1.40s.

The question did not arise in the 1990s. Interest rates converged at the end of the decade but most of the time the cost of borrowing in Britain was far higher.

For the 1980s we have to go back to 1981, and the monetarist experiment of Paul Volcker (Greenspan’s predecessor) for a sustained period when US rates were higher. There may be a lesson there. Sterling had been very strong, above $2.40, but then began a fall that took it almost down to one-for-one parity with the dollar by the mid-1980s. The pound’s weakness prompted several bouts of interest rate hikes.

Will history repeat itself? Could the pound, as so often in Britain’s monetary policy history, force a higher level of interest rates than the economy needs? In its inflation report the Bank notes that the pound’s average value, the sterling index, has moved in a relatively narrow range during the eight years of independence.

Sterling has been a piggy in the middle between the dollar and the euro. In the past five years, for example, the pound has climbed by as much as 25% against the dollar (not so long ago it threatened to hit $2), while falling by 10% against the euro. The position now is that the dollar is strong, the euro relatively weak.

If the pound’s mid-Atlantic pattern continues - being buffetted by the waves from Europe and North America but not moving very much - there will be little to worry about. The trouble is, it is not just in America that rates are rising. The European Central Bank, which admittedly has interest rates of only 2%, is preparing the markets for a hike. On Friday Jean-Claude Trichet, its president, signalled a rise in rates hike as early as December 1.

Currencies are not, of course, purely influenced by relative interest rates. If they were we would all be foreign exchange millionaires. The dollar will have interest rate support but its gaping current account deficit puts up a big question-mark against any sustained rise. Higher European interest rates could be negative for the euro if they are seen as nipping an incipient economic recovery in the bud.

But this one needs to be watched. King’s “nice” (non-inflationary, consistently expansionary) decade was helped by a strong and stable pound. If the pound gets up to some of its old tricks it will be provide another reason why things might not be very nice at all.

PS When I was growing up we lived in a two-and-a-half bedroomed semi but the friends I envied most lived in prefabs. These were warm, cleverly-designed, two-bedroomed bungalows and seemed extraordinarily modern. Constructed as an emergency response to the post-war housing shortage, they could be erected in a day.

Their design life was 15 years, and 157,000 of them were built over the period 1945-49, when Clement Attlee was Labour prime minister.

I say this because close to where I live a row of prefabs, well looked after and with neatly-tended gardens, has just been knocked down to make way for a new housing association project. Necessary though the new homes may be, it looks like an act of vandalism, equivalent to sending a collection of vintage cars to the breaker’s yard because they don’t meet modern emission standards.

John Prescott’s modern version of the clearances, demolishing perfectly good housing to make way for the new, has been much commented on. Some 14,000 new homes will be built on former NHS sites for key workers and others.

This month the deputy prime minister announced the successful bidders under his Design for Manufacture competition for the first four sites on which new £60,000 homes will be built. They include Barratt, Wimpey and Crest Nicholson. The question is whether they’ll be held in the same affection, or last as long, as the old £500 prefabs.

From The Sunday Times, November 20 2005


Hi David,

So if sterling falls the costs of imports goes up, companies realise they can sell their products for more outside of this country (hence, exports rise), less goods are sold in this country so the price increase... all in all, inflation rises.

So what will happen to interest rates? Won't the rise to combat this? Or will politics get in the way again?

Posted by: JZ at November 20, 2005 02:18 PM


Please could you explain your assupmtion on sub $40 oil? Why, by when, and for how long?

My gut instinct is that you are perhaps correct, particularly in the medium term. But it is very much a lone view, and my internet research only seems to turn up articles on peak oil, the number of cars in China, the US still expanding and shrugging off a massive trade deficit - the list goes on.

A comment on your article generally - normally you offer some sort of a view on how you expect things to pan out, albeit with different scenarios. This time though you seem to have commented on a very odd situation, but left it hanging with "If the pound gets up to some of its old tricks it will be provide another reason why things might not be very nice at all."

Are you suggesting that we might be on the verge of the major imbalances in the world economy and the asset/debt "bubble" coming together in an unpredictable collision that will leave us in uncharted waters? Or do you believe that this is just another sequence of events that can if handled correctly be ridden out again by King and his global oppos continuing his "nice" era.

I try hard to understand what is going on, but right now I have the distinct impression that I am not alone (including in the upper echelons) in watching in bemusement as many of the old reference points are cast aside.

No doubt when we look back with the benefit of hindsight it will all make sense!



Posted by: David Brown at November 20, 2005 05:22 PM

On sterling, in an earlier incarnation I used to be a currency forecaster and I know how hard it is. As I say in the piece, if interest-rate differentials were all that determined currency values, making money would be easy. Even on that basis, it could be argued that sterling's loss of interest rate support is already in the price. The main surprise coming through at present is stronger growth in Europe, which should argue for a lower sterling level against the euro. The big unknown is whether the dollar's strength persists or whether the US current account deficit will hit it.

On interest rates, a significant sterling fall would indeed get in the way of further cuts and force rates higher.

On oil, I expect sub-$40 prices within the next 12-18 months, possibly sooner. Demand is increasing, from China and elsewhere, and so is supply. I accept that there has been an increase in oil's long-run price from the mid-$20s to the mid-$30s, a big shift. I don't accept there has been a shift from the mid-$20s to a sustainable $60, $80 or $100 a barrel.

Posted by: David Smith at November 20, 2005 06:06 PM


It seems that the Sterling is currently in problems. This will obviously mean the UK imports inflation from outside countres. Also, this makes the energy price problems worse for UK. Is it not now time you stop being in peoples pockets and tell people the truth. Interest Rates in UK are going to have to go up as is the global trend. Please exploin your thoughts to me.


Posted by: Jean Pierre Bulle at November 22, 2005 04:11 PM

Everybody believes in conspiracy theories - must be something to do with the internet. I write what I believe to be right, not for anybody's convenience. A sterling collapse, if it happened, would force interest rates higher, that goes without saying. A gradual fall, at a time of slow growth (and therefore spare capacity) might not. Indeed the Bank of England might welcome it as a contribution to rebalancing the economy.

In the absence of that, why don't UK rates have to rise when America, Europe and possibly Japan are hiking? Because the UK had rate rises, from 3.5% to 4.75%, when they were stuck at 1%, 2% and 0% respectively. The Bank gave the clearest of signals last week that it does not see the need for rate hikes.

Posted by: David Smith at November 22, 2005 04:33 PM

David - I well remember the last period of raised rates in 1989 - the recession was blamed on Lawson pegging to the ERM and running an expansiory policy - but something just doesn't make sense in this picture.
How do you explain the recession being worldwide from 1989-1992?

I believe that the US dollar rose as higher interest rates kicked in, and other currencies with strong dollar trading links - like the pound - dropped sharply against it, meaning the raised dollar imports quickly fed through to cost push inflation.

I feel strongly that this picture is behind the globalised nature of the recession in 1990-1992 and the dollar will again surprise on the upside.

Posted by: Martin Hutchinson at December 2, 2005 12:06 AM

I dont see an abatement in china's economic growth, a raging train at the moment which will cause a break much slowly, but even if it slows down because of currency movements, there are other asean economies to take its place, notably India. When will oil price acheive sub-40 levels?

Posted by: Hitesh Damani at May 5, 2006 01:47 PM

But, I don't really understand why the UK holds a stong sterling.Because it can limit UK's export.
Can you give me a more convincing evidence?
p/s give sources of statistic/data.

Posted by: Trang at April 6, 2008 03:52 PM