Martin Wolf of the Financial Times has argued that the UK’s real exchange rate was “grossly overvalued” before the recent plunge, which represents a “move towards equilibrium” (see comments to previous post). The evidence presented below suggests the degree of overvaluation was modest and sterling is now “grossly undervalued”, with unfavourable implications for future UK relative inflation performance.

The first chart shows J P Morgan’s real broad trade-weighted exchange rate index, based on a common-currency comparison of UK manufacturing prices (ex. food and energy) with prices in 46 developed and emerging economies. The index was 14% above its 1970-2006 average at sterling’s peak in January 2007. This average, however, is biased downwards by a very low real exchange rate in the 1970s, when UK trade performance was damaged by non-price factors such as poor quality and supply unreliability. Relative to an average calculated over 1985-2006, the deviation was 7% in January 2007. The subsequent fall has pushed the index 19% below this average to the lowest level since 1978.

Exchange rate overvaluation should be reflected in a worsening trade balance. The second chart shows the goods and services balance excluding oil expressed as a percentage of current-price GDP. The trade position deteriorated significantly over 1997-2001 following a large rise in the exchange rate between 1996 and 1998. Once sterling stabilised, however, so did the trade deficit, suggesting that, after an initial negative impact, UK suppliers adjusted to the higher currency. If the pound had been “grossly overvalued”, UK firms would have continued to lose market share, implying further deficit widening.

The third chart shows the percentage of CBI manufacturing companies citing price competitiveness as a constraint on exports. Firms may interpret the survey question as asking whether they are able to win orders at the current level of the exchange rate, in which case responses will also reflect non-price influences on competitiveness. Consistent with this, the CBI measure suggests a smaller degree of undervaluation in the 1970s than the J P Morgan real exchange rate index. It also supports the view that UK manufacturers adjusted successfully to the 1996-98 appreciation, with an initial rise in the measure reversed over 2000-03. In contrast to the J P Morgan index, the CBI series was close to its 1972-2006 average in January 2007. It is currently at its lowest level since 1974.

Previous posts have argued that sterling’s plunge may deliver little net stimulus to the economy, partly reflecting adverse effects on banks’ capital and funding. Unless reversed, it will also result in higher UK inflation than elsewhere. The real exchange rate is unlikely to remain at its current very depressed level over the longer term. A recovery can occur either via nominal appreciation or higher relative inflation. A return of the J P Morgan index to its 1985-2006 average over 10 years, coupled with a stable nominal exchange rate, would imply UK manufacturing prices rising 2.2% per annum faster than in competitor countries.

Postscript: The previously-documented pattern of sterling weakening when Bank of England Governor Mervyn King gives a speech was repeated last week. Mr. King spoke on Tuesday evening; the effective index fell by 1.4% between the closes on Monday and Wednesday.