Stephen King: Sterling's Nineties replay could end in tears

With fiscal policy relatively loose, monetary policy is being asked to deliver an awful lot
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Do you remember that poignant moment, all those years ago, when Paul Gascoigne burst into tears near the end of the World Cup semi-final with England facing a penalty shoot-out against West Germany? When Gary Lineker indicated to the bench - and, unintentionally, to the whole world - that Gascoigne was distraught?

You probably think that Gascoigne's emotional response reflected his booking, ruling him out of the final prematurely before, of course, all the other players were ruled out when Chris Waddle fluffed his penalty kick. But I heard a rumour that Gazza was distraught for other reasons. Apparently, he was worried about the demise of British manufacturing industry and the dangers of recession. I heard that Gazza had picked up a copy of the Financial Times that morning and realised that the British economy was heading south rapidly. Why? Because sterling was fast approaching $2. How could we survive with sterling at this incredibly uncompetitive level?

And, if this unlikely story turns out to be true, Gazza was absolutely right to be upset. England went on to lose the 1990 World Cup semi-final, Graham Taylor was appointed England manager, Norman Lamont was appointed England (make that UK) finance director, and both England and the British economy went into a rapid tailspin. Strong sterling paved the way for a very weak economy indeed. The late-1980s boom gave way to the early-1990s recession and the England soccer team entered the international wilderness, unable to qualify for the 1994 World Cup in the US and falling at virtually every other hurdle (or Hoddle) over the following few years.

I mention all this for an obvious reason. For the first time in more than a decade, sterling has returned to those dizzy heights, threatening once again to pass through the $2 high water mark. And, oddly enough, there's a football competition around the corner, this time the European Championships, where England once again hope to do very well.

For those of you who are not football fans, you'll be pleased to know that I am not going to spend the rest of the column trying to analyse the connection - if any - between sterling strength and England football results. Instead, I'm going to focus on the reasons for sterling's strong performance and, more importantly, what it all means for the economy and for policy decisions.

Let's establish a few facts first of all. On the whole, sterling is not so strong. It might be dirt cheap to have a holiday in the US or in any other country that shadows the dollar, but it's still quite expensive to head off to Europe. The trade-weighted exchange rate, compiled by the Bank of England, is in the middle of the levels seen at various times over the last 10 years, even allowing for its rather rapid ascent over the last few weeks.

Sterling is not that strong against the euro. Again, it's risen a bit over the last few weeks (which, on the chart, is shown as a decline in the euro's value against sterling) after an earlier substantial sell-off but, as my left-hand chart shows, it's really doing nothing special. The big moves took place at the end of the 1990s. Back then, sterling was recovering strongly after its post-Exchange Rate Mechanism nadir, and the foreign exchange markets were taking something of a dislike to the euro. The moves we've seen recently pale into insignificance compared with these earlier extremes.

Against the dollar, though, sterling does look genuinely strong (see right-hand chart.) So, are we going back to the bad old days of the early 1990s, or are Gazza's fears completely irrelevant this time round?

The obvious point to make is that it's not so much sterling strength as dollar weakness. So, what does dollar weakness mean for the UK? A number of points are worth making. First, those companies and investors who bought US dollar assets over the last few years will find themselves rather short-changed. In effect, the dollar's decline is America's way of defaulting on all those foreign investors who - perhaps unwisely - chose to buy into the late-1990s version of the American dream.

Second, those British companies that earn a lot of their profits in the US will be hit by currency translation effects: a weak dollar implies low US profits for UK companies in sterling terms. Third, there will be a competitive loss for UK companies trying to sell their goods and services into the US - not just against US companies but also against Chinese and other Asian companies who are also keen to sell into the US but who have not seen their currencies rising against the dollar. Fourth - and the modest piece of good news in this intricate story - commodity prices that have risen rapidly in dollar terms over the last couple of years will not rise very much in sterling terms, thereby reducing the risk of any external upward pressure on UK inflation.

Quantifying these effects is difficult at the best of times. Because sterling's overall trade-weighted exchange rate has not risen very far, it might be reasonable to conclude that there's likely to be little overall damage. Yet this argument ignores one key point: our competitiveness may be all right compared with continental Europe, but being competitive against a sclerotic part of the world when you're losing competitiveness against the other, more dynamic, regions, doesn't look like a winning longer-term strategy.

Moreover, this argument assumes that sterling won't rise much further. Yet recent unease about sterling's strength is justified not just on the basis of its strength against the dollar but also its now independent virility, its ability to levitate not just against the dollar but also against the euro and countless other currencies.

One perfectly reasonable response to this independent strength it to dismiss it, to suggest that sterling has already overshot its fair value. After all, on previous occasions when it's threatened the $2 level, sterling has sniffed, taken a brief look, and then retreated back to a more comfortable level.

There is, though, something slightly odd about the current situation. Sterling is strong in part because the Bank of England is raising interest rates at a time when the Federal Reserve is in no hurry to do the same - why bother when US inflation is still well behaved? - and when the euro's strength against the dollar may eventually force the European Central Bank to cut interest rates.

And there's an additional factor at work. If the Bank of England were raising interest rates purely to deal with threatened inflation, sterling strength would simply reduce the need to raise rates still further, because currency strength should help lower inflationary pressures (lower import prices, more pressure on exporters to control domestic costs).

But if the Bank of England is raising interest rates for other reasons - notably to slow the domestic housing market and to lower the growth of consumer borrowing - it may be forced to turn a blind eye towards sterling. Which is another way of saying that, once again, policymakers may be providing the foundations for an unbalanced recovery. With fiscal policy relatively loose, monetary policy is being asked to deliver an awful lot: control of inflation, control of the housing market and control of consumer borrowing. Over the long term, these three objectives need not be inconsistent with one another, but they most definitely can be over the time horizon of a typical policymaker. And, once these inconsistencies emerge, something has to give: and, for the time being, it looks as though sterling is having to take the strain.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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