The 23% plunge in the effective exchange rate over the last 12 months is the largest annual fall since the pound was forced off the gold standard in 1931. The rate of decline is greater than during the 1976 IMF crisis and after sterling’s expulsion from the exchange rate mechanism in 1992 – see first chart.
Policy-makers and economists have cheered on the depreciation on the view that it will support activity at little inflation cost. This is based partly on the favourable aftermath of the ERM decline – growth rebounded in 1993 while inflation fell further. This recovery, however, reflected a revival in domestic demand in response to interest rate cuts – the monetary transmission mechanism was working – more than a boom in net exports. The economy was improving before exit from the ERM, having entered recession in 1990, and a huge negative “output gap” outweighed the inflationary impact of the lower exchange rate.
When the Thai baht collapsed in 1997, the boost to net exports was swamped by a contraction of money and credit as foreign capital fled the country. The UK is not Thailand but sterling’s plunge could accelerate a withdrawal of foreign funds from the banking system, exacerbating the credit crunch.
British banks’ net sterling borrowing from overseas stood at £113 billion in August 2007, just before the run on Northern Rock. Surprisingly, this increased over the subsequent 12 months, reaching £200 billion in August 2008 – so foreigners initially supplied more funds to struggling banks. The trend, however, may have turned: £37 billion was repaid in September and October combined and sterling’s plunge could accelerate withdrawals.
The consensus view that the lower currency carries little inflation risk may also be questioned. The second chart shows annual rates of change of manufactured import prices and the effective rate, the latter inverted. The relationship suggests import cost inflation will reach an annual 15-20% in early 2009. With manufactured imports accounting for 17% of domestic demand, this implies a 2.5-3.5% boost to economy-wide prices, excluding second-round effects. The “output gap” is widening rapidly but its impact should be smaller than in 1992-93 – it turned negative only in the third quarter, according to the OECD. Plunging commodity prices and the VAT cut will ensure significantly lower headline consumer price inflation in 2009 but the decline may fall short of MPC and consensus expectations.