Sunday, October 09, 2016
More nasty lurches ahead on this sterling rollercoaster
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The pound in your pocket is worth a lot less than it was, as Harold Wilson did not quite say. Actually, the reference to the most famous devaluation broadcast in history is not inappropriate. The former Labour prime minister was trying to tell people in 1967 that a 14% fall in the pound would not make them any poorer. After another torrid week, sterling’s average value is also 14% lower than it was in late May, before referendum jitters set in.

It was torrid even before the “flash crash” that hit sterling in the early hours of Friday morning, and which pushed it as low as $1.15, before it settled at a weak $1.24.

The current prime minister, who last week declared herself untroubled by the pound’s renewed tumble, will not be broadcasting to the nation about it. She also broke the unwritten rule, adopted by ministers and prime ministers since independence in 1997, of not criticising the impact of the Bank of England’s policies. This was not the first time she had criticised low rates and quantitative easing (QE), though I doubt it will have any impact on what the Bank decides to do in coming months.

Is Theresa May right to be sanguine about the pound’s drop to new 31-year lows against the dollar and a five-year low against the euro?
In the short-term, up to a point. A weak pound is providing a safety-valve for the economy now, as it did in 2007-9, when the global financial crisis hit.

Together with the actions of the Bank, it represents a dramatic loosening of monetary conditions, at a time when the economy needed it. The rebound from the July wobbles owed at least something to the sterling safety-valve.

And, while the pound in your pocket will be worth less as the inflationary impact of sterling’s fall comes through via higher import prices, it is better that that process starts when inflation is very low (0.6%) and oil and commodity prices relatively weak. One of the reasons that there has been less of an inflationary uptick so far is that we had a weak summer for oil prices.

Has the pound, thanks to the Brexit vote, merely found its natural level? One useful way of thinking about where sterling should be is looking at long-term averages. The 10-year average for the dollar against the pound is $1.64, while the 30-year average is very close, $1.65. So $1.24 looks very cheap. The average for the euro to the pound since the beginning of 1999, when the single currency was launched, is €1.37. So, again, €1.11 – sterling’s new five-year low against the euro - looks very cheap. It is enough to push Britain down from fifth to sixth largest economy in the world; back below France.

A more sophisticated approach, pioneered by the Peterson Institute for International Economics in Washington, is to calculate what are known in the jargon as fundamental equilibrium exchanges rates (Feers). It redoes the calculation twice a year. When it last did so, in May, the “right” rate for dollar-sterling was $1.52 and, using its calculation for dollar-euro, the appropriate euro-sterling rate was around €1.26.

All of which suggests that the pound has fallen to a level at which it is now undervalued. That could mean a short-term bonanza for exporters; short-term because currencies do not stay undervalued for too long. Or it could mean that Britain’s economic prospects have deteriorated so much that a significantly lower exchange rate is justified.

The pound’s latest tumble came as ministers – and the prime minister – were setting out their stalls at the Tory conference in Birmingham. It dashed hopes, for now at least, that the EU settlement will involve something close to existing single market arrangements but with some restrictions on free movement. That may never have been a possibility but the Tory conference, with its sometimes xenophobic emphasis on immigration, and a clear message that controlling immigration takes priority over the single market, confirmed it. “Smexit” – single market exit – is now seen as a certainty by the City, and damaging certainty at that. Philip Hammond, the chancellor, is fighting the fight on that, and the battle to remain in the EU customs union, but he is outnumbered by the Brexiteers.

So sterling has sold off, bringing memories of previous episodes of pronounced weakness. It might have been expected to recover some ground on the evidence that the short-term damage from the Brexit vote has been less than feared. In Wilson’s day it was the “gnomes of Zurich” who did all the selling. These days it would probably be the wolves of Wall Street or, given London’s dominant role in currency trading, perhaps the cheeky chappies of Chigwell. Or maybe the robots.

How worried should we be? In a piece for the OMFIF (Official Monetary and Financial Institutions’ Forum) website, Desmond Lachman, a fellow of the American Enterprise Institute said he found it difficult to understand the complacency “surrounding the likely fallout from a ‘hard’ Brexit – particularly at a time when the UK is suffering from acute external; vulnerabilities that are heightening the prospects of yet another sterling crisis”. Having witnessed a few of those over the decades, my ears pricked up.

The biggest vulnerability is, of course, the current account deficit, nearly 6% of gross domestic product. It will be helped by the pound’s fall, but perhaps not quickly enough to remove the danger.

A falling pound only turns into a proper sterling crisis when action – notably higher interest rates – is need to stem the slide. In January 1985, when the pound fell to all-time lows against the dollar (a smidgeon above parity), interest rates were pushed up from 9.5% to 14%. That was just one of many episodes of sterling-generated pain.

Lechman raises the possibility of a monetary response to sterling’s weakness though, with the Bank having only just cut rates – and signalled its intention of doing more – that looks a long way off.

Even so, we should take note of sterling’s weakness. Theresa May says she does not want to give a running commentary on Britain’s Brexit negotiations. Then again, she would not want a feeble pound to provide the backdrop for her government. It is saying that a struggle lies ahead, at the end of which the uplands will be far from sunlit.

Markets, of course, do not have perfect foresight. Hammond, interviewed by Bloomberg on his post-Tory conference visit to New York, suggested a “win-win solution” in Britain’s negotiation with the EU; one that starts with hard positions on both sides but which develops into a mutually beneficial outcome. He appears to have the task in government of trying to clear up the mess created by his colleagues, including May. We have to hope his optimism is justified. The pound’s future performance will tell us whether it is or not. Expect, as he has acknowledged, some more sickening lurches on this rollercoaster.