The pound is back above $1.68 and there are forecasts that it will go to $1.80. Against the euro it is at 82p, just about the highest for a year. Britons like a strong pound, partly because we take a lot of foreign holidays but also because a rising sterling is a statement of confidence in the economy, or at least that foreigners have confidence in our economy.
But therein lies a puzzle, a concern, and a question. The puzzle is why is the pound so strong? The concern is what does a stronger pound do to exports? And the question is whether the rise will enable the Bank of England to delay the rise in interest rates that we all know is on the cards, either at the back end of this year or sometime next?
What’s strange is that the rise in the pound has coincided with a surge in the current account deficit, now running at more than four per cent of GDP. You can explain away a deficit of, say, two per cent of GDP without too many worries, but one of this size is pushing it. By rights, a current account deficit should weaken a country’s currency, as covering it would require a huge amount of net inward investment (the balance of payments has to balance, so a current account deficit has to be offset by a capital account surplus). But the reverse seems to have happened: the bigger the deficit, the stronger the pound.
We don’t have a full answer to this, but you can see bits of it. There may well have been a surge in inward investment, thanks to the UK’s present safe-haven status. We may not think of the UK as a safe haven, and to many people here the recovery still seems fragile. But in a world of confusion, sterling-denominated assets don’t look too bad. Besides, though the pound has recovered by roughly 10 per cent on its trade-weighted index, it is still nearly 15 per cent below its pre-crisis peak. Viewed that way, it does not look particularly over-valued. Markets look forward. They expect the UK to grow faster than other developed economies over the next year or so, and they expect a further rise in property prices. All this underpins the present strength.
But what about the impact on British industry? Surely any rise in the pound will price exporters out of the business and encourage imports? Well, that used to be the case. The early 1990s devaluation, when we came out of the European exchange-rate mechanism, did indeed boost manufactured exports. The subsequent climb of sterling from 1997 onwards did coincide with a fall in global export share. But this recent fall does not seem to have helped exports much, if at all, and it has boosted inflation, thereby cutting living standards. Maybe nowadays price is no longer so important to manufactured trade, or at least the lags in response are very long, and we all can see the drag on living standards from poor inflation performance.
Companies may see a further reason for welcoming the recovery in sterling, which is that it may delay the rise in interest rates. Will it? The argument runs like this. If you want to damp down the economy by monetary means you can do it by increasing interest rates. Credit becomes more expensive, people become more cautious, house prices don’t go up by so much and so on. But an increase in the exchange rate has a similar impact. Our goods and services become more expensive and we lose some foreign orders. Our houses become more expensive to foreign purchasers and maybe some of them hold off. Fewer visitors come, or at least those who do are more careful about what they spend. And so on. The Bank of England used to have a rule of thumb that a four percentage-point increase in the exchange rate was equivalent to a one percentage-point in interest rates. It no longer follows that, but would acknowledge that a rise in the pound does have some monetary tightening effect.
This suddenly becomes rather political. A rise in interest rates on conventional calculations is probably needed before the general election next year. But that might been seen as a political gesture, or at least might have political fall-out. In any case the new Governor, Mark Carney, has sought to play down the possibility of a rise this year. So maybe some targeted measures to damp down the housing market, plus the rise in sterling, will do the trick instead.