Will the pound decline enough to save exports?

News Analysis: Interest rate decisions will hang on the fate of the pound

THE POUND'S decline to a near two-year low against the dollar yesterday, following the publication of minutes showing an 8-1 majority on the Monetary Policy Committee for this month's rate cut, was the most significant weakening in the exchange rate since last autumn. Could it be that, just as the damaging impact of the strong pound on exports is beginning to emerge in the trade figures, the currency is on the verge of a sustained decline?

The answer to that question is central to future interest rate decisions. The majority view on the MPC was that sterling had, month after month, failed to weaken as expected. This made it more likely that inflation would fall below the Bank's central forecast.

On the other hand the lonely minority view of Mervyn King was that: "The benign effects on inflation of the rise in sterling and falls in import prices would be wearing off as domestic activity recovered."

The deputy governor clearly holds to the view in the last Inflation Report that there is a danger the pound will dive far more sharply than the gradual decline pencilled in by the Bank's economists.

The difficulty in forecasting whether the exchange rate will fall is that nobody entirely understands why it rose so much in the first place. The pound is only about 5 per cent higher than its central level during the period of Britain's membership of the Exchange Rate Mechanism, but has climbed a staggering 26 per cent from its low point in 1995.

There are three main candidate explanations for the massive rise in 1996 and 1997. One is that the economy's fundamental strength has improved so much that the UK warrants a higher exchange rate.

Michael Dicks at Lehman Brothers said: "The pound's fundamental strength might be a bit better than it was. That is why the trade performance has been so good." In contrast to the late 1980s, the trade position has not got dramatically worse - at least until now.

A second argument is that UK interest rates were higher than rates on competing dollar, euro and yen assets, partly reflecting the position of the economy in the business cycle. UK rates have been the highest in the G7 for most of the 1990s and were climbing until last summer because growth was so buoyant.

A third is the "safe haven" argument that sterling was stronger to the extent it provided investors with shelter from Europe's monetary union. And indeed, any piece of news suggesting the chances of British entry have receded tends to be greeted with a knee-jerk rise in the pound-euro exchange rate.

All of these could have played a part in the pound's appreciation, but each has different implications for the outlook now. Not surprisingly, analysts' opinions vary widely.

Paul Krugman, the eminent Professor of Economics at the Massachusetts Institute of Technology, is sceptical about the euro's prospects for recovery against both sterling and dollar because he believes the ECB and member governments have done too little to stimulate growth. "The euro area has a deflationary bias," he said. "Where is the growth going to come from?"

He also argues that the architects of the single currency made a strategic mistake in starting it off at a value so close to parity with the dollar. "This gives a parity of one a psychological salience that it does not deserve on any fundamental economic grounds, and makes it hard to conduct a rational monetary policy," he said.

His views appear to be shared by the US administration, which in recent months has pressed Europeans to take up some of the burden of keeping the world economy afloat. Most of the appreciation of sterling has been against the euro and its predecessor currencies; the pound-dollar rate has been remarkably stable.

Paul Meggyesi, a currency expert at Deutsche Bank, agreed that the upturn in the British economy would buoy the pound, regardless of this month's rate cut. "If the UK economy is on the up and leading Euroland, then the euro-sterling rate is not about to turn around," he said.

However, many City analysts think the euro could be gaining ground against sterling in six months' time, with growth on the Continent now starting to pick up.

According to Paul Mortimer-Lee, chief economist at Paribas: "The pound's strength reflected the economic recovery." Signs of renewed growth in Europe will now take sterling lower against the euro, he predicted, while the expected increase in US rates by the Federal Reserve will also weaken it against the dollar in the short term.

Michael Saunders, an economist at Salomon Smith Barney, also predicts the pound will decline gradually, largely because he expects the MPC to continue cutting interest rates to keep the UK economy afloat. "People do not appreciate how severe the drag on growth and inflation from the strong pound will be," he said.

Many also expect sterling to weaken further against the dollar, as it did yesterday, thanks to the likely increases in US interest rates. The Fed is expected to raise its key policy rate to match the UK's 5 per cent as early as next week. Mr Mortimer-Lee said: "In the longer run the aim is to slow the American economy down, which will hit the dollar. But the rate crossover with the US is why a lot of people are now talking about sterling weakness."

But even among those experts who agree with Mr King's analysis that the outlook for sterling is weaker, there are differences of view about how far and how fast it could fall. A gentle decline would be welcome; a steep fall might require an increase in interest rates to keep inflation on target.

As members of the MPC have been at pains to emphasise, they are not targeting a weaker exchange rate. The only target is the inflation target. However, the committee's debate has made the pound the focus of attention. Its fortunes on the foreign exchanges hold the key to interest rates.

Suggested Topics
Life and Style
Customers can get their caffeine fix on the move
food + drink
Voices
Mosul dam was retaken with the help of the US
voicesRobert Fisk: Barack Obama is following the jihadists’ script
Life and Style
techCould new invention save millions in healthcare bills?
Arts and Entertainment
Loaded weapon: drugs have surprise side effects for Scarlett Johansson in Luc Besson’s ‘Lucy’
filmReview: Lucy, Luc Besson's complex thriller
PROMOTED VIDEO
News
peoplePamela Anderson rejects ice bucket challenge because of ALS experiments on animals
Life and Style
food + drink
Arts and Entertainment
tvExecutive says content is not 'without any purpose'
News
A cleaner prepares the red carpet for the opening night during the 59th International Cannes Film Festival May 17, 2006 in Cannes, France.
newsPowerful vacuum cleaners to be banned under EU regulations
Arts and Entertainment
tvSpielberg involved in bringing his 2002 film to the small screen
Sport
sportLeague Managers' Association had described Malky Mackay texts as 'friendly banter'
News
A polar bear’s diet is rich in seal blubber and half of its own body weight is composed of fat
i100
News
ebooksAn evocation of the conflict through the eyes of those who lived through it
News
peopleCareer spanned 70 years, including work with Holocaust survivors
News
people
Travel
Flocking round: Beyoncé, Madame Tussauds' latest waxwork, looking fierce in the park
travelIn a digital age when we have more access than ever to the stars, why are waxworks still pulling in crowds?
News
London is the most expensive city in Europe for cultural activities such as ballet
arts
Arts and Entertainment
Jeremy Clarkson has rejected criticisms of his language, according to BBC director of television Danny Cohen
tv
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Application Support - Enterprise Java, SQL, Oracle, SQL Server

£45000 - £55000 per annum: Harrington Starr: A well-established financial soft...

Service Desk Analyst (Graduate, Helpdesk, Desktop, Surrey)

Negotiable: Harrington Starr: Service Desk Analyst (Graduate, Helpdesk, Deskto...

Service Desk Analyst (Graduate, Helpdesk, Desktop, Surrey)

Negotiable: Harrington Starr: Service Desk Analyst (Graduate, Helpdesk, Deskto...

Junior Quant Analyst - C++, Boost, Data Mining

£25000 - £35000 per annum: Harrington Starr: Junior Quant Analyst - C++, Boost...

Day In a Page

Air strikes? Talk of God? Obama is following the jihadists’ script

Air strikes? Talk of God? Obama is following the jihadists’ script

The President came the nearest he has come yet to rivalling George W Bush’s gormless reaction to 9/11 , says Robert Fisk
Ebola outbreak: Billy Graham’s son declares righteous war on the virus

Billy Graham’s son declares righteous war on Ebola

A Christian charity’s efforts to save missionaries trapped in Africa by the crisis have been justifiably praised. But doubts remain about its evangelical motives
Jeremy Clarkson 'does not see a problem' with his racist language on Top Gear, says BBC

Not even Jeremy Clarkson is bigger than the BBC, says TV boss

Corporation’s head of television confirms ‘Top Gear’ host was warned about racist language
Nick Clegg the movie: Channel 4 to air Coalition drama showing Lib Dem leader's rise

Nick Clegg the movie

Channel 4 to air Coalition drama showing Lib Dem leader's rise
Philip Larkin: Misogynist, racist, miserable? Or caring, playful man who lived for others?

Philip Larkin: What will survive of him?

Larkin's reputation has taken a knocking. But a new book by James Booth argues that the poet was affectionate, witty, entertaining and kind, as hitherto unseen letters, sketches and 'selfies' reveal
Madame Tussauds has shown off its Beyoncé waxwork in Regent's Park - but why is the tourist attraction still pulling in the crowds?

Waxing lyrical

Madame Tussauds has shown off its Beyoncé waxwork in Regent's Park - but why is the tourist attraction still pulling in the crowds?
Texas forensic astronomer finally pinpoints the exact birth of impressionism

Revealed (to the minute)

The precise time when impressionism was born
From slow-roasted to sugar-cured: how to make the most of the British tomato season

Make the most of British tomatoes

The British crop is at its tastiest and most abundant. Sudi Pigott shares her favourite recipes
10 best men's skincare products

Face it: 10 best men's skincare products

Oscar Quine cleanses, tones and moisturises to find skin-savers blokes will be proud to display on the bathroom shelf
Malky Mackay allegations: Malky Mackay, Iain Moody and another grim day for English football

Mackay, Moody and another grim day for English football

The latest shocking claims do nothing to dispel the image that some in the game on these shores exist in a time warp, laments Sam Wallace
La Liga analysis: Will Barcelona's hopes go out of the window?

Will Barcelona's hopes go out of the window?

Pete Jenson starts his preview of the Spanish season, which begins on Saturday, by explaining how Fifa’s transfer ban will affect the Catalans
Middle East crisis: We know all too much about the cruelty of Isis – but all too little about who they are

We know all too much about the cruelty of Isis – but all too little about who they are

Now Obama has seen the next US reporter to be threatened with beheading, will he blink, asks Robert Fisk
Neanderthals lived alongside humans for centuries, latest study shows

Final resting place of our Neanderthal neighbours revealed

Bones dated to 40,000 years ago show species may have died out in Belgium species co-existed
Scottish independence: The new Scots who hold fate of the UK in their hands

The new Scots who hold fate of the UK in their hands

Scotland’s immigrants are as passionate about the future of their adopted nation as anyone else
Britain's ugliest buildings: Which monstrosities should be nominated for the Dead Prize?

Blight club: Britain's ugliest buildings

Following the architect Cameron Sinclair's introduction of the Dead Prize, an award for ugly buildings, John Rentoul reflects on some of the biggest blots on the UK landscape