The increased political and economic uncertainty as highlighted in Hetal’s last post, makes finding a fair value for the pound difficult. Without an anchor, the pound could struggle to stabilise until there is more hard data on the impact of Brexit on the real economy, or more visibility on the new relationship between the UK and the EU.
There are a number of ways to estimate the fair value of the pound. Any attempt that uses other financial market variables is erroneous as those prices are affected by the same heightened risk premium, and because net trade is rather insensitive to the exchange rate, using the current account to back out a level of the pound that shrinks the deficit to more sustainable levels won’t work either.
As a result, we have resorted to looking at purchasing power parity (PPP) and initially focus on the pound against the US dollar. We do not argue that the pound should trade at PPP levels, but we estimate how cheap (to PPP) the pound could trade by looking at previous shocks.
Two clear outliers are the pound’s slide out of the European exchange rate mechanism in 1992 and the great recession (including the bank run on Northern Rock), but both involved serious systemic shocks.
Given our central economic outlook and the aforementioned political uncertainty, we believe that more weakness in the pound is to be expected. However, this time around the financial authorities appear to be better prepared and we don’t think a systemic shock is imminent. We therefore don’t subscribe to the view that the pound will fall to extremely cheap levels on a PPP basis and do not expect the pound to trade sustainably below 1.20 to the US dollar.
For a more detailed discussion, please refer to the original Macro Matters publication.