One of the most striking features of the UK economy in recent years has been the stability of the exchange rate. Having fallen by 10% following Britain's exit from the ERM, the trade-weighted exchange rate has hardly moved for two years. The question is: will this situation persist or will sterling resume its long-term decline?
The difference between UK and overseas interest rates is, in the short term, a fairly reliable guide to the path of the exchange rate (see chart). With the UK further ahead in the economic cycle than either Japan or Continental Europe, the interest rate premium looks set to widen: a year from now, short-term interest rates in the UK are likely to be nearly two percentage points higher than overseas. Against this background, says Schroder Economics, sterling is more likely to rise than fall.
There are other reasons for being optimistic about the outlook for sterling. Higher taxes and a healthy economic recovery mean that the public sector borrowing requirement is falling quite sharply. This is restraining imports, bringing the current account back towards balance and reducing UK reliance on overseas finance. With low inflation - by international standards - the UK is also managing to remain competitive. There's no pressure to devalue in order to restore a loss of competitiveness. Although political risks could be a threat, higher interest rates, low inflation and a current account surplus are may well push sterling up by around 3% over the next year. Appreciation is likely to be most pronounced against the Deutschmark and the yen, with sterling rising to DM2.60 and Y171.