March 15, 2013 8:53 pm

Weakening pound raises stagflation fears

British Currency

The Bank of England seemed relaxed until this week about the fact that sterling has lost almost 6 per cent of its value against big trading partners’ currencies this year. But governor Sir Mervyn King on Thursday signalled a change in attitude when he said the pound was now “properly valued”. His remarks came as the weakening currency fuelled fears that stagflation – a potentially pervasive mix of inflation and economic stagnation – could be stalking the British economy.

1 What has driven sterling down?

Sterling has been hit by a cocktail of problems. It has lost much of its haven appeal as risks posed by the eurozone crisis and the US fiscal cliff abated. At the same time the UK economy is suffering, with estimates suggesting that it is flatlining at best. This has increased expectations that Mark Carney, who succeeds Sir Mervyn as BoE governor at the end of June, will usher in an era of even looser monetary policy in an attempt to boost growth. This is in stark contrast to the US where the dollar has been boosted by more positive economic news.

2 How far will the pound fall?

Sterling’s most recent fall remains small in historical terms. At the start of the financial crisis, the pound fell 30 per cent against the US dollar compared to 7 per cent so far in 2013. Similarly, sterling’s fall versus the euro was near 26 per cent in 2008 and 6 per cent so far this year. Estimates as to how much further sterling might fall vary but most analysts expect gradual weakening rather than a sudden plunge. Modest falls to levels near $1.45 in the medium term are most often mentioned versus the US dollar, alongside estimates near £0.90 versus the euro.

3 Why should we care about sterling?

As Easter looms, many families will start to think about summer holidays. Should they go abroad or opt for a domestic “staycation”? In tough times, the answer for many will be influenced by the value of sterling. The higher it is, the more can be consumed abroad for fewer pounds.

A legitimate concern for families looking at a 6 per cent fall in the pound in under three months is whether Britain faces a loss of international confidence and a potential sterling crisis.

4 Why did the BoE talk down sterling last year?

When sterling rose against rival currencies in 2012, in reaction to fears over the eurozone crisis and the US fiscal cliff, Sir Mervyn made increasingly shrill comments about the rise being “not a welcome development”. This reflected the BoE’s view that a weaker exchange rate was a necessary condition for economic rebalancing and recovery by making UK exports more competitive.

5 Why, then, is Sir Mervyn sounding the alarm now?

He is concerned that what started as a welcome depreciation was potentially becoming a rout. Sir Mervyn had indicated that he wanted sterling to give up its rise of the second half of 2012 and now that it has, he has indicated enough is enough. “Basically we’re at the same level [of sterling] we were after the impact of the financial crisis … we’re certainly not looking to push sterling down,” he said. Any lower and the rise in import prices would add another squeeze to household finances and raise inflation.

EADS is not going to go somewhere else to buy aircraft landing gear because the exchange rate has moved

- Lee Hopley, EEF

6 Will Carney’s arrival in July affect sterling?

No one knows for sure. But it is clear that the new governor is keen on a more activist stance to monetary policy to get the UK economy to what he describes as “escape velocity,” where growth will be self-sustaining. The expectation of looser monetary policy in the months to come would probably push sterling lower, although currency markets are notoriously difficult to predict. That said, important voices in the BoE are urging caution. Spencer Dale, the bank’s chief economist, warned on Friday that looser monetary policy could threaten inflation’s stability in the longer term as it did in the 1960s and 1970s. “We must remember the mistakes of the past,” he cautioned.

7 Why have exports not benefited more?

Despite the weaker pound, imports have remained high and exports have disappointed. Lee Hopley, of the EEF manufacturers’ organisation, said there were fewer UK suppliers than in the past, so while a weak pound makes export sales cheaper, it raises the cost of imported components and raw materials. Also, many exports are of niche products, which are less price-sensitive. “EADS is not going to go somewhere else to buy aircraft landing gear because the exchange rate has moved,” Ms Hopley says.

David Kern, chief economist at the British Chambers of Commerce, warned that a further drop in sterling would be damaging. “We have ... reached the point where the benefits of a weaker pound for UK exports will be very small, while the potential damage to the economy because of high inflation and the squeeze it imposes on businesses and consumers is much bigger.”

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