On Thursday 6th December the Bank of England bowed to the inevitable and cut the UK’s base rate for the first time in this cycle, from 5.75% to 5.5%.
Although equities gave back some of the aggressive gains from the previous session on the news the most startling reaction took place in the currency markets where sterling resumed its marked decline against both the euro and the dollar.
Having called sterling up to $2.11, a 26-year high we could find few reasons to support the British currency’s continued strength. Indeed it is our view that the pound will weaken further against the dollar over 2008 (and that both currencies will weaken against the euro as interest rate differentials exert a powerful force). We now look for cable to end 2008 at $1.90.
Sterling not used to justify cut
Interestingly, for all the reasons cited by the Bank to justify its decision to cut UK base rates, sterling was not one of them. Strikingly, sterling had declined by c3% against a basket of currencies over the seven days prior to the decision and by 6% from the highs reached in the summer.
Indeed the trade weighted index has fallen to 99.2, a more precipitous decline than that envisaged by the Bank’s Monetary Policy Committee (MPC) in the November Quarterly Inflation Report.
However, the Bank is unlikely to press the panic button yet. Trade weighted sterling, although at its lowest level since April 2006, is still only just below its average level over the past two years. Secondly, the MPC must have factored sterling weakness into its equations prior to making the decision to cut the base rate.
Frankly, the combination of slowing economic activity coupled with the prospect of a series of base rate reductions over the course of the next twelve months (we forecast UK base rates at 5.0% by end 2008 with the risk lying to the downside) is hardly a rejuvenating cocktail.
Weaker exchange rates: an alternative to lower base rates?
Two further points need making. Firstly, if sterling is falling because the economy is weakening, the potentially adverse impact of the currency’s depreciation on inflation is likely to be muted. Secondly, the MPC may actually encourage sterling to fall further on the basis that at least part of the monetary loosening it now regards as necessary will come in the form of a weaker exchange rate rather than aggressively lower base rates.
What happens if currency depreciation continues?
Where sterling does become a headache for policymakers is when the currency continues to fall sharply on the foreign exchanges at a time in which the Bank is still concerned about lingering inflationary pressures…like now!
Given the deterioration in the domestic economy, to say nothing of the growing structural deficits that make the UK look increasingly like a mini version of the US, a sharp depreciation in the currency cannot be overlooked.
Were the depreciation to gather pace, an event we do not rule out, we fear that the MPC might view such a development as alarming from an inflationary perspective, limiting the scope for further rate cuts and in consequence raising the spectre of a more lengthy and severe economic downturn than is currently being factored into forecasts.
By Jeremy Batstone-Carr, Director of Private Client Research at Charles Stanley