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
PROMOTED VIDEO
Arts and Entertainment
'New Tricks' star Dennis Waterman is departing from the show after he completes filming on two more episodes
tvOnly remaining original cast-member to leave long-running series
Arts and Entertainment
Game Of Thrones
Uh-oh, winter is coming. Ouch, my eyes! Ygritte’s a goner. Lysa’s a goner. Tywin’s a goner. Look, a dragon
tvSpoiler warning:The British actor says viewers have 'not seen the last' of his character
Sport
The Etihad Stadium, home of Manchester City
premier league

The Independent's live blog of today's Premier League action

News
Rumer was diagnosed with bipolarity, attention deficit hyperactivity disorder and post-traumatic stress disorder: 'I was convinced it was a misdiagnosis'
peopleHer debut album caused her post-traumatic stress - how will she cope as she releases her third record?
Life and Style
Couples have been having sex less in 2014, according to a new survey
life
Voices
Holly's review of Peterborough's Pizza Express quickly went viral on social media
voices
News
ebooksAn unforgettable anthology of contemporary reportage
Sport
Radamel Falcao was forced to withdraw from the World Cup after undergoing surgery
premier leagueExclusive: Reds have agreement with Monaco
Arts and Entertainment
musicBiographer Hunter Davies has collected nearly a hundred original manuscripts
Sport
A long jumper competes in the 80-to-84-year-old age division at the 2007 World Masters Championships
athletics
Arts and Entertainment
tvReview: 'Time Heist' sees a darker side to Peter Capaldi's Doctor
Life and Style
Walking tall: unlike some, Donatella Versace showed a strong and vibrant collection
fashionAlexander Fury on the staid Italian clothing industry
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

Senior BA - Motor and Home Insurance

£400 - £450 Per Day: Clearwater People Solutions Ltd: **URGENT CONTRACT ROLE**...

Market Risk & Control Manager

Up to £100k or £450p/d: Saxton Leigh: My client is a leading commodities tradi...

SQL Developer - Watford/NW London - £320 - £330 p/d - 6 months

£320 - £330 per day: Ashdown Group: The Ashdown Group have been engaged by a l...

Head of Audit

To £75,000 + Pension + Benefits + Bonus: Saxton Leigh: My client is looking f...

Day In a Page

Scottish referendum: The Yes vote was the love that dared speak its name, but it was not to be

Despite the result, this is the end of the status quo

Boyd Tonkin on the fall-out from the Scottish referendum
Manolo Blahnik: The high priest of heels talks flats, Englishness, and why he loves Mary Beard

Manolo Blahnik: Flats, Englishness, and Mary Beard

The shoe designer who has been dubbed 'the patron saint of the stiletto'
The Beatles biographer reveals exclusive original manuscripts of some of the best pop songs ever written

Scrambled eggs and LSD

Behind The Beatles' lyrics - thanks to Hunter Davis's original manuscript copies
'Normcore' fashion: Blending in is the new standing out in latest catwalk non-trend

'Normcore': Blending in is the new standing out

Just when fashion was in grave danger of running out of trends, it only went and invented the non-trend. Rebecca Gonsalves investigates
Dance’s new leading ladies fight back: How female vocalists are now writing their own hits

New leading ladies of dance fight back

How female vocalists are now writing their own hits
Mystery of the Ground Zero wedding photo

A shot in the dark

Mystery of the wedding photo from Ground Zero
His life, the universe and everything

His life, the universe and everything

New biography sheds light on comic genius of Douglas Adams
Save us from small screen superheroes

Save us from small screen superheroes

Shows like Agents of S.H.I.E.L.D are little more than marketing tools
Reach for the skies

Reach for the skies

From pools to football pitches, rooftop living is looking up
These are the 12 best hotel spas in the UK

12 best hotel spas in the UK

Some hotels go all out on facilities; others stand out for the sheer quality of treatments
These Iranian-controlled Shia militias used to specialise in killing American soldiers. Now they are fighting Isis, backed up by US airstrikes

Widespread fear of Isis is producing strange bedfellows

Iranian-controlled Shia militias that used to kill American soldiers are now fighting Isis, helped by US airstrikes
Topshop goes part Athena poster, part last spring Prada

Topshop goes part Athena poster, part last spring Prada

Shoppers don't come to Topshop for the unique
How to make a Lego masterpiece

How to make a Lego masterpiece

Toy breaks out of the nursery and heads for the gallery
Meet the ‘Endies’ – city dwellers who are too poor to have fun

Meet the ‘Endies’ – city dwellers who are too poor to have fun

Urbanites are cursed with an acronym pointing to Employed but No Disposable Income or Savings
Paisley’s decision to make peace with IRA enemies might remind the Arabs of Sadat

Ian Paisley’s decision to make peace with his IRA enemies

His Save Ulster from Sodomy campaign would surely have been supported by many a Sunni imam