Has the Bank of England helped stem economic decline?

December 23, 2009

MarkBolsom.JPG-Mark Bolsom is the Head of the UK Trading Desk at Travelex, the world’s largest non-bank FX payments specialist. The opinions expressed are his own.-

The onset of 2009 saw the pound well and truly on the back foot against both the dollar and euro, at one stage hitting a six-year low against the greenback (falling to $1.3751) and an all-time low versus the single currency. In one week in January, the pound fell 4.5 percent against the euro, 5.7 percent against the yen and 6 percent against the dollar.

The pound’s weakness at that stage was clearly a direct consequence of the credit crunch and resulting global economic slowdown. Nevertheless, as the both the government and the Bank of England opted for policies of aggressive fiscal and monetary stimulus, sterling recovered, to a degree, even as the economy slid into the deepest recession for generations. In response, the Bank of England took positive and decisive action, slashing interest rates to a record low of 0.5 pc and pumping 200 billion pounds into the economy through its asset purchasing scheme.

How successful this has been is debatable. House prices have stabilised and have been slowly rising. The threat of deflation also appears to have receded with November’s data showing inflation more or less in line with the Bank’s 2 percent target. Similarly unemployment has not risen by as much as had been feared. However, as 2009 draws to an end, the government has been forced to revise its own growth forecasts for 2009 downwards, now stating that by year end the UK economy will have contracted by 4.75%. Similarly, some commentators have argued that unemployment data is misleading. True, the number of claimants is still below expectations, but many employees have been forced to accept pay cuts and shorter working weeks.

Worryingly, at the time of writing, Britain also remains the only major economy not to have emerged from recession. The final Q3 GDP number revealed that the economy still contracted by 0.2 percent in the three months to September. Furthermore, significant question marks remain over the long-term sustainability of Britain’s debt, as the government and taxpayer now have to cope with the cost of successive bank bailouts.

Therefore, sterling’s prospects for 2010 look decidedly mixed. Given the level of economic uncertainty we certainly expect interest rates to stay at their current level of 0.5 percent – at least until 2011- as both the Bank of England and the government will want to stimulate economic growth. Traditionally, this could be expected to lead to a further weakening of the pound as demand diminishes. Mervyn King, governor of the Bank of England, has consistently argued that this is needed in order to rebalance the economy and stimulate the UK’s export sector, although such a move is likely to be unpalatable to the UK consumer.

Low interest rates could also be expected to lead to a higher rate of inflation as money supply increases and imports, upon which the UK relies heavily, become relatively more expensive. We could very well see consumer price inflation hitting the 3 percent mark early next year.

Ultimately, the relative performance of sterling will depend as much upon other economies as it does upon the UK’s own economic fundamentals. However, there is little doubt that markets will want to see the key areas of actual economic growth and the burgeoning UK budget deficit decisively tackled, before offering sterling any significant support. These issues are also likely to become major points of debate in the run up to next year’s election.

Whatever the outcome of next year’s election, we expect the pound to remain weak across the board, as the challenges facing the British economy will remain the same, with sterling’s performance over the next twelve months likely to heavily influence future economic policy. King has already put down his marker, arguing strongly in favour of a weaker pound. Quite whether politicians are prepared to follow him remains, as yet, to be seen.

How successful do you think the Bank of England have been in stemming the UK’s economic downturn? Post comments below or email me your thoughts at mark.bolsom@travelex.com

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