It’s the question I always get from members, but I absolutely hate forecasting exchange rates.
It’s a mugs game and I’m terrible at it. (It’s been said that fx forecasting makes astrology look good).
Part of the problem is the varying short-term (interest rate differentials), medium-term (purchasing power differentials) and long-term (balance of payment adjustments) that drive exchange rate movements.
But there’s a lot in the news today about exchange rates, so i’m going to talk about their impact (if not their likely direction of travel).
[NOTE: The Bank of England sees raising interest rates as an incredibly crude and harmful way of popping a housing bubble, and so the Financial Policy Committee (FPC), which makes such assessments has a variety of other policy tools to use if it remains concerned about house prices. But that fact won’t stop speculation about the MPC raising interest rates before next spring.]Expectations of a rate rise are pushing up Sterling
As noted above, expectations of a rise in interest rates in the UK, relative to other countries, tends to push the value of a currency up.
So Sir John Cunliffe’s speech stating that a housing bubble risks derailing the economy has raised expectations of an early rate rise from the Monetary Policy Committee (MPC) and pushed Sterling up. Part of the problem with the London/UK housing market is the influx of foreign buyers. A historically cheap pound had made the London housing market a relatively cheaper investment. A stronger pound is a natural market mechanism to correct that (at least over the medium term, as noted above).
Lower profit margins
Hopefully economic commentators will have learned that the direct link between exports and the currency is only really the stuff of Econ 101: cheaper currency, means cheaper goods, means more sales. That hasn’t held true for the UK.
In the real world (ie a small, open economy with export-oriented manufacturing sectors) it makes more sense to price in your customers’ currencies rather than the production currency.
In manufacturing, it is incredibly important to have predictability over demand (and therefore resource planning).
If a big chunk of your turnover comes from exports, pricing in your own currency means your price can change frequently, removing predictability. If you price in others’ currencies, you push the impact on to margins, which is far easier to handle as a business than demand uncertainty.
So the recent rise in sterling will place margins under pressure. And as companies are currently investing out of retained earnings, pressure on margins could translate in to pressure on investment.
Lower inflation
A stronger currency would also keep inflation rates low, because it makes the price of imported goods cheaper. Lower inflation will help the MPC, in terms of the inflation pressures.
Note, this helps keep costs down for manufacturers that import a high degree of their inputs.
What does it all mean?
I’m not worried about the impact of a stronger sterling on the manufacturing recovery – manufacturers stopped competing solely on the basis of price long-time ago.
My hunch is that interest rates will go up sooner rather than later, that there are more factors pushing sterling up, than dragging it down (at least in the short-term) and that housing bubble remains the primary risk to the UK economy.
Other than that, your guess is as good as mine (and probably better!).
