A falling exchange rate causes inflation concerns for the UK

This week has seen some developments for the UK economy including a scare on Monday as the value of the pound took a real dive on the foreign exchanges with it being down more than 4 cents against the US dollar at one point during the day. In some respects even more significant was the fall against the Euro, this is because it is also a weak currency and we had maintained quite a tight trading range against it (1.13/15 or so) in spite of falling against other currencies. Since then we have recovered a little but remain down on the week. As I pointed out on Monday we had been on a declining trend for a month or so in terms of our exchange rate. Sadly for the “one-day ” journalists this is is not exciting enough news but for an economist like me it is significant. 

“If we look at the effective exchange rate where the Bank of England looks at all exchange rates and our international trade to calculate a trade weighted index then we have fallen from 81.66 on the 27th January to 77.92 on Friday’s close”. This was the situation I reported on Tuesday,since then we fell to a low of 76.654 on Tuesday night and have since recovered a little to 77.115 as of last nights close. So now the screaming headlines have gone the truth is that we have dropped by 5.56% as an international currency since the 27th January 


Until something fundamentally changes it is hard to see this trend changing. Now markets ebb and flow and we have not fallen in a straight line but we seem to be in a period when the US dollar is strong and the Yen has been strong throughout the credit crunch. So in a way the real measure in my view is the Euro,simply because it is a weak currency like us. 

Those who have followed my updates on UK inflation prospects will know that I have concerns that the current uptick could become a longer-term feature of our economic landscape. Falls against the US dollar directly impact imported prices because so many assets/raw materials are priced in dollars. For example oil,wheat,metals,sugar.maize,orange juice,gold and so on…. Hence the phrase “imported inflation”. It is a concern to me. Having just looked at our daily closes against the US dollar according to the Bank of England our recent peak was at 1.6796 on the 17th November and we closed last night at 1.5054. This is a fall of 10.37% and will be feeding through directly to the prices of the raw materials I have described above. Please remember that when someone is telling you there is no inflation danger going forwards. 

Todays Producer Price Inflation Report 

These measures are a signal of what inflation is coming through the economic system as opposed to the Consumer Price Index and Retail Price Index who try to measure what is already there. So they are seen as a forward-looking indicator which means that they are expected to feed through into the other two measures of inflation I have just mentioned as time passes. 

The output price index rose by 4.1% in February compared with 3.8% in January 2010. According to the Office for National Statistics this mainly reflected rises in chemical products,tobacco and alcohol and other manufactured products. To give you an idea of the trend here are the figures for this index for the last 6 months 0.4,1.8,2.9,3.5,3.8,4.1. If I was on the Monetary Policy Committee I would be very concerned. 

The input price index rose by 6.9% in February which compares with 7.7% in January 2010. According to the Office of National Statistics there were price rises in imported parts and equipment,chemicals and other imported materials but there was also an offsetting fall in the price of crude oil. Again let me show the figures for the last 6 months, -6.2%,0.5%,4.2%,7.4%,7.7% and 6.9%. 


These figures I think speak with an eloquence. I always counsel caution with all economic date and the Office of National Statistics in its report says that the latest 2 months figures may not have all the data. However if you look at the trend for both indices it is worrying I feel, There appears to have been a slight dip in input prices but this is counterbalanced by the fact that it is at virtually 7%. 

Remember also that the full effect of the fall in our exchange rate has yet to be felt in these figures so there are genuine reasons to feel that these figures will come under upward pressure in the months to come. As I have posted before I feel that our watchdog the Monetary Policy Committee is asleep to these dangers and welcome the fact that some members of the so-called “shadow” Monetary Policy Committee are more alert as  believe three of them stated that they would raise interest rates this month. 

Government Bond Maturity 

I have mentioned this before but I wish to add some new insight and have been asked several questions recently on this subject. It also favours the UK and we need some good news! 

Each year governments go to the debt markets not only to finance their fiscal deficit but also to roll-over their existing debt (unless they are able to re-pay some of it). As we are in a situation where sovereign debt issue around the world is very high and rising it is clearly a benefit to have as little debt as possible to roll-over. In the UK  currently our debt maturity 14 years which means that on average we have 1/14th of our existing debt to refinance each year. This is partly by fortune as our pension industry likes long-term debt to set against its annuity liabilities but it is also true that the Treasury and Bank of England have done this deliberately and in this crisis they deserve a well done I think. As an aside you do not get many good news stories about annuities do you? 

Internationally we compare well and the real laggard is the United States whose debt maturity is less than five years, Germany is not a lot better at 6 years and the country in the news Greece is 8 years. For the United States this could turn out to be a real problem if the sovereign debt crisis escalates and more surprisingly Germany could be caught up too. Perhaps being considered a safe haven has led to laxity and complacency, or simply the law of unintended consequences is at play again. 






One thought on “A falling exchange rate causes inflation concerns for the UK

  1. “If I was on the Monetary Policy Committee I would be very concerned. ” Your concern would be wasted, I suggest, since the MPC no longer have any power to act, even if they wanted to. The members have in any case been hand chosen by Brown, to ensure that they will tow the government line without dissent. Now of course they have to follow the instructions of government, i.e. Brown. (Look at the written terms of their appointment. At any time Brown is empowered to take back control of base rate, which he clearly did now over 1 year ago. He is not required to announce this action, and thus did not do so.) Principally because the government has now borrowed so much, and also because the government has to soon call a general election, Brown wants as low a base rate as possible, because he hopes that will help win another term. That is why base rate has stayed at 0.5 % for one year despite inflation being consistently higher than that and that it is now rising significantly.

    “As I have posted before I feel that our watchdog the Monetary Policy Committee is asleep to these dangers and welcome the fact that some members of the so-called “shadow” Monetary Policy Committee are more alert as believe three of them stated that they would raise interest rates this month.” I do not think it is so much that the MPC members have `been asleep to the dangers’; I think they are in a position of not being able to do the right thing for the long-term economy, even if they wanted to. Most of them believe in Socialist economics in any case, and believe thus that they can redistribute wealth with inflation, as Lenin did, and that it is much better to save the economy from the necessary natural correction which is required (and will be unavoidable eventually). They seem to believe also that with the current gambits they can avoid the recession being worse or turning to depression permanently, and can exploit savers to help bail out the problems of over-indebtedness, despite rising inflation.

    In any case the remit of the MPC has only one authorised action if you read their remit – to adjust base rate to control inflation to 2 %. They have no authority to take any other action whether fiscal or economic, particularly not to authorise QE, which must produce the opposite effect of their remit. Indeed by dong so they have been acting illegally, without any official government authority.

    So I do not believe that any of their members has been asleep. I believe they have condoned the inflationary action deliberately to generate inflation, and that is why none of them speak out against it, nor state what they know in reality is the correct action, as you summarise in today’s blog. The MPC is now directly under the control of Brown, and their supposed decisions are political decisions.

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