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Business analysis: Exchange rates: A high pound must not become entrenched, says Phillip Inman

June 17, 2014

Phillip Inman

Three months ago the pound was worth fractionally less than euros 1.20 - now a pound will buy euros 1.25. A similar trajectory in the sterling rate for the US dollar has breached $1.70 after years of trading in a band between $1.55 and $1.65. Cue for dire warnings of a kick in the teeth for manufacturers and a gnashing of teeth by exporters.

Much of the rise has come in the last two weeks and can be attributed to a honking horn from the European central bank that signalled cheaper money for the eurozone. The UK sent the opposite message: the Bank of England's governor, Mark Carney, last week made it clear that the UK was nearing a period of monetary tightening.

While it was clear that ECB boss Mario Draghi needed to cut borrowing costs for households and businesses in response to virtually zero growth, it was less obvious why Carney shifted his stance. Only a few weeks ago he was defending his long-held position that the economy is weak and in need of help from the Bank. An interest rate rise was scheduled for next spring. Now it could happen in November after he said: "The first rate hike . . . could happen sooner than markets expect."

Maybe the stronger than expected jobs figures last week influenced his view. After a year in which self-employment accounted for almost half of all new jobs, the last three months have shown employers recruiting in big numbers for more typical full-time roles. That said, wages growth is half the rate of inflation, which is the perfect excuse for sticking to a consistent line.

There is a view inside Threadneedle Street that a higher exchange rate is no bad thing, at least in the short term. Imports will be cheaper and therefore inflation will be lower for longer, offsetting other pressures on the Bank to raise rates quickly. Trouble comes with a high exchange rate that becomes entrenched. That's when exporters decide the pound is working against them to such an extent that they may as well give up.

Policymakers fear this outcome, but in the past have failed to put on the brakes, with each period of high exchange rates over recent decades resulting in a sharp decline in manufacturing output and employment. Draghi was doing his best to maintain a fall in the euro's value with his interest rate cuts.

Economic consultants Fathom Consulting reckon the Banks longer term view that rates will stay below 3% will have a dampening effect on sterling and limit its recent rise. Carney must be betting they are right. Get it wrong and he could be blamed for killing yet another slice of British manufacturing.

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Source: Guardian (UK)

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