When sterling gets a pounding
In recent days, currency markets have taken a dim view about the direction the UK is heading. Aside from the ‘flash crash’ (when the exchange rate briefly plummeted to 1.18 against the US dollar), what is driving the lurch down, what are the consequences and how worried should we be?
Some currency weakness is perhaps not surprising given the UK’s large 6% of GDP current account deficit. However, while the post-referendum economic data readings have exceeded our cautious expectations, concerns around a ‘hard Brexit’ have increased following the tough-rhetoric from the Conservative Party conference. Theresa May’s focus on immigration and the full return of UK sovereignty appears to be taking priority over single market access.
As a result, since James wrote in his post a few weeks ago, the drop in the pound has accelerated. Based on an exchange rate assumption of 1.20 vs the dollar, we would expect to see inflation pick up more aggressively and overshoot the BoE’s 2% target as shown in the chart below.
Take the Tesco versus Unilever spat; the cost of imports rising is prompting Unilever to increase their prices by 10% across the board, while Tesco is currently refusing to stock their products. While some retailers may try to limit the inflation pass-through, some impact is unavoidable.
So how will the Bank of England react? The consensus is the MPC will look through any currency-related rise in inflation. But that view must surely hinge on continued uncertainty and weak investment. If growth was to shrug off the impact of Brexit and head back toward 2%, then the BoE could have to shock markets and hike rates to bring inflation back down. But whilst investment intentions remain weak and uncertainty about future trading arrangements linger, it will be difficult for the BoE to hike interest rates.
Brexit might be like Marmite – you either love it or hate it – but it affects everyone.
P.S. I won't miss pot noodles, but I’m starting to worry about not getting my favourite shampoo…!