What is next? Will the pound depreciation continue in 2017-2018?

#Brexit Facts

Part 2

Exchange rate developments are hard to predict as they react to various internal/external developments at the same time. This being said, I will discuss 3 key issues, which suggest that the pound will not recover to its value before the Brexit vote and may depreciate even further against major currencies in the years to come.

1. Persistent uncertainty regarding the EU-UK relationship in the future: The triggering of the Article 50 implies that the UK will leave the EU in March 2019. After being delayed due to general elections, UK started Brexit negotiations started in June 2017 without a mandated government and a clearly communicated strategy. Moreover, given the legal and practical complexity of reaching a satisfactory arrangement, it is very likely that the Brexit talks continue for some time. Markets do not like uncertainly, moreover the pound is not an international reserve currency in the same way as the dollar is. As a result, business and consumer confidence, which are already at low levels, may deteriorate further throughout the year. Therefore, I expect investors to continue to shy away from the pound, which will hinder the recovery of the exchange rate.

2. Prospects of low growth and productivity: The governor of the Bank of England stated in June 2017 that weaker real income growth was likely to accompany the transition to new trade arrangements with the EU. The UK is expected to be poorer after Brexit with lower incomes bringing weaker demand and an economy functioning under its potential. The Bank of England and many major institutions have recently lowered their UK growth forecasts up to 2019. Obviously, weaker growth expectations will continue to hold the value of the pound down in the future.

3. Monetary tightening in the US and euro area: Investors seeking high returns purchase assets of countries that offer high interest rates. That is to say, high interest rates render a country’s assets attractive to foreign investors and increase the demand for for the country’s currency. Obviously, this higher demand triggers the appreciation of the currency. 

After almost a decade of accommodative monetary policy, growth and unemployment in the US and euro area are finally recovering. The Fed has already started to gradually raise interest rates and the European Central Bank is also preparing to do so. Turning to the UK, the picture is rather different:  Economic growth decelerated significantly in the first quarter of 2017. On the other hand, the UK inflation reached 2.9% in May 2017, a rate well above the 2% policy target. Therefore, the Bank of England is facing a tremendous policy challenge. Raising interest rates ‘too soon’ in an environment of continued economic uncertainty and weak demand is likely to hinder economic activity. On the other hand, lack of reaction to inflationary pressures may also pave the way to ‘stagflation’, a concertedly dreaded illness by economists and policy-makers. All in all, the decoupling of the UK interest rates from the rates of the other major economies would result in a relatively weak pound exchange rate vis-à-vis the dollar and euro.

Based on these three aspects, my take is that, pound is unlikely to recover to its value before the Brexit vote and could depreciate further in 2017-2018. In an import-relying economy like the UK, a weak currency drives inflation up by making imports of energy, food, raw materials and intermediate goods more expensive. The UK producers declare that they have not yet fully passed the increasing input costs on retail sale prices. This implies more inflation and lower real incomes in the future.

Next Thursday, I plan to discuss the appropriate policy responses to the UK’s economic challenges. A largely missing topic from the current political debate…

I hope you found this article helpful. Please leave me a comment for feedback and questions.