Senior Bank of England officials appeared before the House of Commons’ Treasury Select Committee on 21 February to report on the state of the economy and the future path for inflation and interest rates. One topic considered was the role of depreciation.
The pound has depreciated since the referendum on EU membership in June 2016. The exchange rate index today is some 9% below that before the referendum and 15% below the peak a year before the referendum.
It had fallen as much as 14% by October 2016 below the level before the referendum and 20% below its peak, pushed down partly by the cut in Bank Rate from 0.5% to 0.25% following the referendum. In November 2017, the Bank’s Monetary Policy Committee raised Bank Rate back to 0.5%. Two or three more rises of 25 basis points are expected over the next couple of years. This has helped to strengthen sterling somewhat. (Click here for a PowerPoint of the chart below.)
But has the depreciation been advantageous or disadvantageous to the economy? Here the Governor (Mark Carney) and the Chief Economist (Andy Haldane) appeared to differ. Andy Haldane said:
A combination of the weaker pound and a stronger global economy has worked its magic. That has meant that net trade has been a significant contributor, and we expect those effects to continue over the next two or three years. … Depreciations work, and that’s how they work.
By contrast, Mark Carney said:
Depreciations don’t work. They have an economic effect, but they’re not a good economic strategy. They may be an outcome of various things … but it’s how you make yourself poorer.
Are these statements contradictory or are they simply emphasising different effects of depreciation?
Both Andy Haldane and Mark Carney would accept that a depreciation makes imports more expensive and thus reduces real incomes (at least in the short run). They would also accept that a depreciation makes exports priced in pounds cheaper in foreign currency terms and thus can boost the demand for exports.
There is disagreement over two things, however. The first is the effect on people’s real incomes in the long run. Will any fall in real incomes from higher-priced imports in the short run be offset in the long run by higher economic growth?
This relates to a second area of disagreement. This is whether a depreciation can act as a significant driver for exports over the longer term. The increased incentive on the demand side (from consumers abroad to buy UK exports) could be offset by a disincentive for exporters to become more efficient and/or to compete in terms of quality. In other words, although it can give exporters a price advantage, the crucial question is the extent to which they take advantage of this, or merely take higher profits.
The disagreements thus relate primarily to the incentive effects over the longer term.
Bank of England governor says Brexit has made us poorer – as it happened The Guardian, Graeme Wearden (21/2/18)
Brexit will knock 5% off wage growth, says Mark Carney The Guardian, Phillip Inman (21/2/18)
Treasury Committee: Wednesday 21 February 2018 Parliamentlive.tv (21/2/18) (see from 16:08:00)
Bank of England documents
Treasury Select Committee hearing on the February 2018 Inflation Report Bank of England (21/2/18)
Inflation Report – February 2018 Bank of England (8/2/18)
Interest & exchange rates data Bank of England
- How does a depreciation affect the demand for and supply of imports and exports?
- What determines the size of the effect on inflation of a depreciation?
- What is the significance of the price elasticity of demand for and supply of sterling in determining the size of depreciation resulting from a change in confidence or a change in interest rates?
- How does productivity growth impact on the effectiveness of a depreciation in leading to higher economic growth?
- In what ways might a depreciation affect productivity growth?
Since the Brexit vote in the referendum, sterling has been falling. It is now at a 31-year low against the US dollar. From 23 June to 6 July it depreciated by 12.9% against the US dollar, 10.7% against the euro and 17.0% against the yen. The trade-weighted sterling exchange rate index depreciated by 11.6%.
Why has this happened? Partly it reflects a decline in confidence in the UK economy by investors; partly it is in response to policy measures, actual and anticipated, by the Bank of England.
As far as investors are concerned, the anticipation is that there will be net direct investment outflows from the UK. This is because some companies in the UK are considering relocating part or all of their business from the UK to elsewhere in Europe. For example, EasyJet is drawing up plans to move its headquarters to continental Europe. It is also because investors believe that foreign direct investment in the UK is likely to fall as companies prefer to invest elsewhere, such as Ireland or Germany.
Thus although the effect of net direct investment outflows (or reductions in net inflows) will be on the long-term investment part of the financial account of the balance of payments, the immediate effect is felt on the short-term financial flows part of the account as investors anticipate such moves and the consequent fall in sterling.
As far as monetary policy is concerned, the fall in sterling is in response to four things announced or signalled by Mark Carney at recent news conferences (see Monetary and fiscal policies – a U-turn or keeping the economy on track?).
First is the anticipated fall in Bank Rate at the next meeting of the Monetary Policy Committee on 13/14 July. Second is the possibility of further quantitative easing (QE). Third is an additional £250bn of liquidity that the Bank is prepared to provide through its normal open-market operations. Fourth is the easing of capital requirements on banks (reducing the countercyclical buffer from 0.5% to 0%), which would allow additional lending by banks of up to £150bn.
Lower interest rates, additional liquidity and further QE would all increase the supply of sterling on the foreign exchange markets. The anticipation of this, plus the anticipation of lower interest rates, would decrease the demand for sterling. The effect of these supply and demand changes is a fall in the exchange rate.
But is a fall in the exchange rate a ‘good thing’? As far as consumers are concerned, the answer is no. Imports will be more expensive, as will foreign holidays. People’s pounds will buy less of things priced in foreign currency and thus people will be poorer.
As far as exporters are concerned, however, the foreign currency they earn will exchange into more pounds than before. Their sterling revenues, therefore, are likely to increase. They might also choose to reduce the foreign currency price of exports, thereby increasing the quantity sold – the amount depending on the price elasticity of demand. The increase in exports and reduction in imports will help to reduce the current account deficit and also boost aggregate demand.
Pound slumps to 31-year low following Brexit vote The Guardian, Katie Allen , Jill Treanor and Simon Goodley (24/6/16)
Sterling’s post-Brexit fall is biggest loss in a hard currency Reuters, Jamie McGeever (7/7/16)
Brexit Accelerates the British Pound’s 100 Years of Debasement Bloomberg, Simon Kennedy and Lukanyo Mnyanda (5/7/16)
Pound sterling falls below $1.31 hitting new 31-year low Independent, Hazel Sheffield (5/7/16)
Viewpoints: How low will sterling go? BBC News, Leisha Chi (6/7/16)
How low will the pound fall? Financial Times (7/7/16)
Allianz’s El-Erian says UK must urgently get its act together or dollar parity could beckon Reuters, Guy Faulconbridge (7/7/16)
What does a falling pound mean for the British economy? The Telegraph, Peter Spence (6/7/16)
Spot exchange rates: Statistical Interactive Database – interest & exchange rates data Bank of England
- What determines how much the exchange rate depreciates for a given shift in the demand for sterling or the supply of sterling?
- Why might the short-term effects on exchange rates of the Brexit vote be different from the long-term effects?
- Why has the pound depreciated by different amounts against different currencies?
- What are likely to be the effects on the financial and current accounts of the balance of payments of the Bank of England’s measures?
- Find out what has happened to business confidence since the Brexit vote. What effect does the level of confidence have on the exchange rate and why?