Sterling plunges as pound slips inflationary anchor
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Foreign Exchange

Sterling plunges as pound slips inflationary anchor

The pound has dropped to its lowest level in two and a half years against the dollar amid a widespread perception that the currency has lost its inflation anchor.

The fact the Bank of England (BoE) chose to keep its asset purchase scheme on hold at its policy meeting last week has done little to deter sterling bears, who still expect the central bank to expand its quantitative easing (QE) scheme in the months ahead as it strives to revive the UK economy and head off a triple-dip recession.


Many expect the Bank to alter its policy framework, with George Osborne, UK chancellor, widely expected to announce a review of its 2% inflation target in his annual Budget on March 20.

Osborne's options include giving the BoE more time to bring inflation back to its target, formally charging it with looking at both inflation and growth, like the Federal Reserve, or even targeting GDP.

With UK inflation stuck at an annual rate of 2.7%, any change would therefore give the Bank scope to engage in further QE and further weaken the pound.

On top of that, incoming BoE governor Mark Carney has signalled he is open to change in the central bank’s policy regime, and would like it in place before he takes up his position on July 1.

Also adding to the pressure on sterling is the message delivered by David Cameron, UK prime minister, that the British government, still reeling from Moody's move to strip the country of its AAA rating, is intent on continuing along the path of fiscal conservatism. Monetary policy, in other words, will be relied on to stimulate the UK economy.

All this has seen inflation expectations grinding higher.

 UK five-year breakevens at post-financial crisis highs
 
Source: Bloomberg 

 

Indeed, breakeven inflation is now probing its highest level in the five years since the onset of the financial crisis, around 3.2%. Furthermore, the deterioration in inflation expectations is accelerating, with the market having added a percentage point so far this year.

As David Simmonds, head of currency strategy at RBS, puts it: “Fast rising inflation expectations, simultaneous with monetary activism and more stimulus, is very negative for sterling.”

There is, of course, also a widespread perception that the UK authorities are happy to see the pound trade lower, delivering a boost to the export sector and encouraging UK consumers to substitute foreign for domestically produced goods and services.

So with GBPUSD having breached $1.50 and, according to many sell-side analysts, heading down to the low $1.40s, the question is whether a weaker pound will have the desired effect on the UK economy.

Steven Englander, head of G10 strategy at Citi, says investors underestimate how much depreciation policymakers have to engineer to generate cyclical recovery with currency weakness.

He says statistical analysis suggests that a 10% depreciation in the pound translates into about a 9% increase in sterling exports within two years.

“So to gain a significant net volume increase, the depreciation has to be very intense,” says Englander.

He says if the UK intends to use export growth as a cyclical driver of its economy, the surprise will be how much the currency has to move.

Trade and industrial production figures released this week in the UK should underline the idea that the UK economy is not rebalancing and the equilibrium exchange rate for sterling lies some way below current levels.     

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