Sterling's recent storm risks intensifying

After rallying to $1.70 in recent weeks, sterling faces new and potentially severe headwinds, writes Ian Campbell.

 

Published: 5:51AM BST 12 Aug 2009

The UK's sanguine summer has suddenly turned unsettled. Not for the first time it was the Bank of England that changed the weather. Its decision last Thursday to print another £50bn has clobbered the previously resurgent pound, which fell by 3pc against the dollar in just two trading sessions. The storms could soon get worse.

The central bank's response to the pound's immediate fall is likely to be: "Oh dear, what a pity, never mind". Spencer Dale, the bank's chief economist, described the exchange rate in June as a "key channel through which the monetary easing may be transmitted". The weaker pound favours exports, tourism – and inflation. The UK's 1.8pc inflation rate is far away from the deflation in the US, the eurozone, Japan and even fast-growing China. Rising prices keep real interest rates low, even negative. That's impossible if deflation gets a grip.

The bank's now £175bn quantitative easing (QE) scheme is intended to be mildly inflationary, as that stimulates GDP growth. But if growth doesn't revive, QE, in the context of the huge fiscal deficit, could prove counterproductive. The government's financing projections call for borrowing of £348bn this fiscal year and next. The danger is that this is beyond what the market will tolerate.

The dollar was undermined earlier this year when the US Federal Reserve committed itself to buying $300bn of government debt. That was just 2pc of US GDP, far less than the BoE's purchases, mainly of government bonds, worth 13pc of GDP.

It would be surprising if the pound did not fall further. Sterling could easily return to its $1.40 lows of earlier this year. That would help the UK economy to revive. But if anxiety about the UK's finances were to turn to panic, the drop could become dangerously steep.

If emergency fiscal measures are required, the central bank could also be forced into an embarrassing change of course.

http://www.telegraph.co.uk/finance/currency/6011675/Sterlings-recent-storm-risks-intensifying.html