February 23, 2015

Is Sterling Overvalued?

Filed under: Economic Crisis, Economic Forecast, Uncategorized — drderrick @ 10:10 am

Over the past five years trade weighted Sterling has appreciated by 8%. Over the same period, it has fallen against the US$ by 6%, and it has fallen against the Yuan by 15% – US$ and Yuan account for 17.5% and 8.9% respectively of the currency basket. The strength of Sterling is entirely due to the weakness of the Euro, which accounts for 46.2% of the currency basket, and against which Sterling has risen by 15%.

Over the past twelve months, while Sterling has fallen against both the US$ and Yuan by 11%, overall the trade weighted index has fallen by only 1%, due again to the weakness of the Euro, against which Sterling has risen by 3%.

Given its great importance, the strength of Sterling against the Euro will have contributed to the startling growth of the UK current account deficit, which now stands at some 6% of GDP – the worst ever! It will also have contributed to the weakness of UK inflationary pressure. Alongside low oil prices, strong Sterling should be seen as one of the temporary contributors to current low inflationary environment.

When the Euro eventually strengthens, the value of Sterling could fall significantly and, together with domestic political factors – discussed here: https://drderrick.wordpress.com/2014/12/29/the-sterling-crisis-of-2015/ – may lead to an overshoot, leading to an undervalued Sterling. While exporters might welcome this, it would also increase inflationary pressures, and the likelihood of the Bank of England raising interest rates.

When this happens the anaesthetising effects of the current interest rate regime will begin to wear off, and the economy will slow.

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