This Thursday, the Monetary Policy Committee of the Bank of England is expected to cut rates by 50 bps to 1 percent. This will bring the overnight rate to the lowest level in the bank’s more than 300 years of history which could make the British pound very vulnerable going forward.
Implications of Lower Interest Rates for the British Pound
In 2008, a rapid weakening of economic growth in the United Kingdom led the Bank of England to cut rates from 5.75% to just 1.5%. The BoE aims to promote sustainable growth and price stability but since inflationary pressures diminished substantially as a result of declines in energy prices, the central bank decided to focus entirely on promoting economic growth. However, by changing its monetary policy objectives, the BoE made the Sterling an easy target. In fact, like “vultures”, who feed mostly on the carcasses of dead animals, global macro traders have no mercy for a currency with an ongoing deterioration of interest rate differentials and the sterling ended up depreciating sharply against several the world’s most liquid currencies. In 2008, the British pound lost more than 67 percent against the yen, 44 percent against the Swiss franc and nearly 36 percent against the U.S. dollar.
Prime Minister Gordon Brown must go
The British economy is officially in a recession, the first one since 1991 when Margaret Thatcher was the Prime Minister of the United Kingdom. Like the current Prime Minister Gordon Brown, Thatcher inherited the economy in a very bad shape. However, Thatcher’s tough-talking style, which gained her the nickname of "Iron Lady", helped the British economy to recover from its downward spiral. However, unlike Gordon Brown’s policy of bailouts, Thatcher’s safeguarded free markets and reduced state intervention. These are two simple concepts which may hold the key to solve the current financial crisis but unfortunately they have been completely forgotten by several policy leaders across the world. So, one has to question the ability of the current Prime Minister to tackle this economic crisis with tough measures since the only thing the PM has been doing well is to give free money to banks which was taken away from the pockets of the British taxpayer.
A Weak Sterling May Trigger a new Wave of Problems in the British Economy
A weak currency has some great benefits for British companies with overseas operations. For example, if British Airways earned USD$100 billion in 2008, at a GBP/USD exchange rate of 2 that would be worth 50 billion pounds. However, since the GBP/USD exchange rate fell recently to 1.4 that repatriated value increases to 71 billion. However, a weak currency also makes the U.K. economy more vulnerable to the outside world since they have to pay a higher price for foreign products and for their government debt. In fact, the purchasing power of an average British has been decreasing sharply over the last few months since it takes more pounds to buy the same foreign products. That is another way to say that further declines in the value of the sterling could trigger an upward movement in inflation which could create a difficult puzzle for the BoE to solve.
Forecast for the British Pound
We expect the British economy to contract by more than 3 percent in 2009, the most since World War II. In fact, recent economic data continues to show a very dark picture of the U.K. economy. House prices continue to fall and conditions in labor markets are worsening quickly. Eventually, this will force the BoE to cut rates to zero percent and trigger a significant shift in interest rate differentials which could keep the GBP/USD under pressure over the next few months.
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