The UK has experienced its longest post war recession, and the deepest since the Great Depression. In 2011, the recovery was disappointing, and prospects for the rest of 2012 are poor. However, the UK recovery is likely to be relatively better than the Eurozone, which retains even more serious problems. Therefore, despite the fact UK interest rates are likely to stay very low (see latest: prospects for UK Interest rates), the Pound should maintain its value against the Euro, and could increase towards the end of 2012..
Basic Economics Behind Predictions for Value of Pound.
The Pound will tend to appreciate (increase in value) under the following circumstances:
- If UK interest rates rise relative to our competitors. If UK interest rates increase it is more attractive to save money in UK banks
- Economic recovery in the UK relative to elsewhere. If the UK economy recovers, the Bank of England will be more likely to increase interest rates back to normal levels
- Low Inflation / Improved productivity. Low inflation makes UK exports relatively more competitive. The best combination is low inflation, plus economic growth
- Confidence in government finances. If markets fear the government could default on its debt. Foreign investors would sell UK bonds causing a fall in the value of the Pound.
- General market sentiment.
- Reduction in current account deficit – i.e. improve in our trade relative to the rest of the world.
Predictions of Pound Against the Dollar
Against the dollar, the Pound could fall. The US economy is predicted to recover the quickest and therefore the US is likely to exit the liquidity trap quicker than the UK. Therefore, US interest rates are likely to rise before the UK. This increase in US interest rates would cause hot money flows to US and appreciate the dollar.
During the 2008-09 recession, the UK economy suffered the most because of its reliance on the financial markets and an asset (housing) boom. The UK recession was very deep, and this was one reason for the 25% devaluation in the Pound in 2007-09. Since then the Pound has maintained a fairly constant value – despite high inflation and a policy of quantitative easing.
Strength of the Pound Relative to Euro
One strength of the Pound relative to the Euro, is that markets are fairly confident about UK government bonds. Bond yields in the UK have fallen. Markets have more confidence in UK debt because the Central Bank can print money to buy bonds and being outside the Euro, the UK retains more flexibility in monetary policy and exchange rate. The UK recovery should be stronger than the Eurozone because
- UK has benefited from past devaluation restoring competitiveness.
- UK has benefited from quantitative easing
- Whilst ECB raised interest rates in 2011, this looked overly optimistic. The IMF have downgraded forecasts for EU growth considerably.
Forecast for UK Inflation
After experiencing cost-push inflation in 2011. Inflation is set to fall dramatically as we no long have cost push factors of
- higher taxes
- imported inflation from devaluation
- rising commodity prices
This sharp fall in inflation, will relatively strengthen the Pound. However, it does make an interest rate increase less likely.
Potential Weakness of Pound
However,, despite a 20% depreciation in sterling, the UK retains a persistent trade deficit suggesting an underlying imbalance in the economy. Since the credit crunch there are less capital flows to finance a current account deficit. Therefore there we may need to have to be a further depreciation to boost exports relative to imports.
Another factor in the equation is the scale of government debt and the purchase of government gilts. This has potential to worry markets and raise future inflationary pressures. Although bond yields have stayed low. Markets will be worried about prospects of a double dip recession in the UK.
Given these factors the prospects for Pound Sterling would usually look pretty grim. Low interest rates and quantitative easing usually would weaken sterling and the government’s fiscal position will not help.
The saving grace for Sterling may be the relative weakness of our competitors. The Euro is starting to look prohibitively expensive, at least for south European economies like Spain and Ireland. Though the Eurozone is emerging from recession, it still looks pretty weak and it could experience a severe double dip recession because of austerity and spending cuts which weaken growth. The ECB takes a fundamentalist approach to keeping inflation low, but, even the ECB will be hard pressed to justify rate increases with the Euro economy so weak.
The good news for sterling is that the worst may (hopefully) be over. If we don’t get dragged down by Eurozone recession, we could emerge from recession, towards the end of 2012.
It is hard to make predictions because the current situation is exceptional with no real precedent. A lot will depend on the nature of recovery. If the UK’s growth continues to be weaker than our competitors sterling will continue its downward slide. But, if the UK grows quicker than expected and confidence is restored in the UK people may switch back to Pounds. But, overall, I think the most likely scenario is that the Pound will remain weak. A lot of us could be spending our summer holidays in old Blighty rather than paying to go to Euroland.