By John Fender, Professor of Macroeconomics at the University of Birmingham.
The UK has experienced a depreciation of about 13% in the value of its currency since the Brexit referendum on the 23rd June last year. The Brexit vote was undoubtedly responsible for most of the decline; if the vote had been to remain the pound would almost certainly have appreciated in value, so the difference the referendum result made was greater than 13%.
Why did the Brexit vote cause the decline? One plausible explanation is that it happened because of the anticipation of the UK facing inferior trading relationships after its withdrawal. Even if it does establish a free trade agreement with the EU, this will be worse than its current arrangement. The complex international supply chains underlying the production of many goods will be disrupted, and the UK will become a less attractive venue for foreign direct investment.
When a price changes, whether one benefits or suffers depends upon whether one is a buyer or a seller of the good in question. So foreign purchasers of UK exports should certainly benefit from a cheapening of the pound, provided that exporters pass on at least some of the change to them by reducing foreign currency prices. Tourism should also gain.
So exports should rise. However, this effect is mitigated in several ways. Given the uncertainty about future trading arrangements, exporters are unlikely to put much effort into developing new export markets. And many exporters buy imports as inputs into their productive processes. As the prices of these imports may have risen as a consequence of the depreciation and might be expected to rise still further, this will have an offsetting effect.
It must be remembered that only a fraction of firms export. But a firm that produces just for the domestic market may still buy imported inputs, so is likely to suffer unless it faces significant competition from imported substitutes for its final product.
Consumers will be concerned about the fact that CPI inflation – the rise in the Consumer Price Index over the past year – has risen from 0.5% in June to 2.3% in the most recent figures for March. The depreciation of the pound is almost certainly responsible for much of this increase. Transport costs, which feed through into many other prices, have risen by about 6.6% in the last year; the rise in the worldwide price of oil has undoubtedly contributed to this; the Brent crude oil price has increased from about £23 last February to £44 a barrel this February – a rise of over 90%.
Inflation is now above the 2% target given to the Bank of England, and seems virtually certain to increase further in the next few months. Given that wages are increasing at about 2% per annum we can expect to see a fall in personal disposable income. This effect may be reinforced by cuts in welfare benefits. So we would expect fairly sluggish growth in consumption as a consequence.
Monetary policy can affect exchange rates; an unexpected cut in interest rates will almost certainly depress the value of the pound. But there is not much scope for further interest rate reductions. In fact the next movement in interest rates may well be upwards, given the rise in inflation and since output seems to be fairly buoyant.
I do not expect there to be significant movements in exchange rates in the near future. As Brexit negotiations proceed, there may be ups and downs as expectations about the outcome of the negotiations change, and there should be plenty of other happenings, especially in the United States, which may affect the exchange rate. However, the expectation must be that the next few years will see sluggish growth in disposable income, higher inflation than we have been accustomed to recently, slowing economic growth and continuing weakness in the exchange rate.
This article was first published in the Greater Birmingham Chamber of Commerce blog.