The Long-term outlook
If the outlook for sterling is largely to be determined by the direction of interest rates, and rates are to be largely determined by inflation rather than the economic outlook, then what is the outlook for UK inflation?
Recent data around both grocery and energy prices indicates that at least some of the inflationary pressures in the economy are dissipating.
Konstantinos Venetis, director of global macro at consultancy TS Lombard, says that the current pattern globally is that inflationary pressures are easing.
More importantly, however, he says that in the UK, the domestically focused element of inflation — which he believes centres on both demand and supply in the services sector — is easing, particularly as wages stop rising at the same pace as previously.
But the decline in inflation will be very slow, Venetis says, adding that this leaves policymakers “in a bind” as to whether to keep raising rates or not.
Gerard Lyons, chief economic strategist at wealth management firm Netwealth, says rising interest rates help to reduce inflation in four ways:
- reducing or limiting the amount of money in the economy;
- squeezing the level of demand in the economy via higher borrowing costs;
- managing public expectations around the direction of inflation;
- driving up the value of the currency relative to peer currencies, which itself is disinflationary, as it should mean imported goods cost less.
Also, as the UK runs a persistent current account deficit, a stronger currency over a prolonged period of time can have an outsized impact on the inflation rate, at least relative to countries that run current account surpluses.
Lyons says higher interest rates take time to filter through to the wider economy, and this presents the Bank of England with a dilemma — since if it put rates up based on the current data, it could be demonstrated to be excessive.
He says: “All this adds to the challenge for policymakers to weigh up the full impact of previous tightening alongside responding, but not overreacting, to the latest economic data.
“People are paying higher prices, not because they want to, but because they have to or can. But as previous policy tightening feeds through, demand will slow and pricing power will ease.”
Lyons believes that the central bank will “retain a bias towards hiking” rates as long as unemployment remains low.
Such an outcome would probably mean that sterling continues to be strong, with the signal that this is likely to change coming from higher unemployment.
He says that long-term inflation will stabilise at between 3 per cent and 4 per cent, rather than the 2 per cent rate or below that has been common in the UK in recent decades.
What that would mean for the strength of sterling over the long term is a function of whether the medium-term inflation rate in the US and eurozone settles at a lower level than the 3 to 4 per cent range.
If it does, then the normal interest rate level in the UK would probably be higher than in those countries, potentially boosting sterling.
Strong sterling may benefit the economy as a whole. But with the majority of the earnings of FTSE 100 companies coming from overseas, the UK stock market does best when sterling is weak relative to the dollar, because the value of dollar profits increases when converted into sterling and paid back as dividends.
So whatever the direction of sterling over the coming months, it will have a profound impact on the portfolios of advisers and their clients.