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OPINION

Backing sterling

Backing sterling
June 20, 2017
Backing sterling

One of these is that the general election result is widely seen as a vote against tight fiscal policy. "Many are tired of austerity," wrote Nick Timothy, Theresa May's former chief of staff recently. We might well, therefore, see a looser fiscal policy - and not just in Northern Ireland.

 

 

Standard economics tells us this should strengthen sterling. The Mundell-Fleming model on which generations of students were tortured says a looser fiscal policy should mean a higher exchange rate. The logic here is simple. Looser fiscal policy implies incipient higher aggregate demand and thus a tendency for higher inflation than we'd otherwise have. For a given inflation target, this should raise interest rates, which should boost sterling.

Note here that higher interest rates are a feature, not a bug. One reason why economists such as Oxford university's Simon Wren-Lewis have advocated a fiscal loosening is precisely that it would get us away from the zero bound on rates and so give the Bank of England ammunition with which to fight any future economic downturn.

There's a second reason to expect sterling to rise: exchange rates, like share prices, can overshoot their fundamental value. Economists have known this for decades. The late Rudiger Dornbusch published his famous overshooting model back in 1976, and it has more recently been updated by Martin Eichenbaum and Sergio Rebelo at Northwestern University and Benjamin Johannsen at the Federal Reserve.

 

 

 

 

My chart shows the point. It plots the real dollar/sterling rate (the nominal rate multiplied by the ratio of consumer price indices in the UK and US) against changes in the nominal rate in the following three years. You can see a strong negative relationship: in monthly data since 1988 the correlation has been minus 0.68. High real exchange rates in 1991 and 2007 led to sterling falling, and low real rates in 2001 and 2010 led to it rising. With sterling's real exchange rate now near a 40-year low, this points to the pound rising.

So, why might all this be wrong? One possibility is that sterling will be depressed simply because the UK will grow more slowly than overseas economies. In the first quarter, UK GDP growth (of 0.2 per cent) was the lowest in the EU and G7 - a pattern that might well continue. Given all the gloom about the UK economy, however, this fact might already be in the price.

A second reason for suspicion is that looser fiscal policy will only strengthen sterling if the inflation target stays at 2 per cent. If it is raised, there need be no rise in interest rates and hence no reason for sterling to rise.

And then there's the unquantifiable but dangerous possibility that overseas investors will simply lose patience with the UK's still-large current account deficit and lack of effective government.

We cannot therefore be wholly confident that sterling will rise. But then, only fools can ever be wholly confident about the future: as regular readers know, I hate futurology.

There is, though, a clearer message here. It is unwise to base your equity strategy upon the assumption that sterling will stay weak. Those of you who have piled into big overseas earners in the hope of continued rises in the sterling value of those earnings are taking a dangerous bet.