UK: Smith on Economics - The x-factor in sterling's strength.

UK: Smith on Economics - The x-factor in sterling's strength. - There's an x-factor behind sterling's strength, David Smith believes, which has resulted in red faces among the market forecasters and should lead to a lower pound.

Last Updated: 31 Aug 2010

There's an x-factor behind sterling's strength, David Smith believes, which has resulted in red faces among the market forecasters and should lead to a lower pound.

We all have a past. Mine included a spell as a currency forecaster.

I can't recall whether my forecasts were any good but it was a lot easier then. Sterling was the foreign exchange markets' favourite 'sell' currency.

As a forecaster, the trick was not to predict sterling's direction but try to guess the speed of its fall. At times, the pound has been unfairly victimised - the UK economy is often over-analysed in the City relative to its size and suffers because London is a key foreign exchange centre.

Even in the run-up to monetary union, other European economies have not been scrutinised in such detail.

But this is no longer the case. A glance over the pound's record in the last decade tells its story. Sterling's average value rose in 1988, after the then chancellor, Nigel Lawson, failed to keep it below DM3. It fell in 1989 as the boom started to go wrong and, again in 1990 when the economy hit recession. Membership of the exchange rate mechanism (ERM) lifted its average value slightly in 1991 but ERM exit in 1992 prompted its famous sharp fall. This continued in 1993, until sterling stabilised and rose slightly in 1994, before dropping 5% in 1995. Since then, it was up slightly in 1996, rose further in 1997 and in the first few months of 1998.

A safe haven role

The point is that, even before its recent climb, sterling had ceased to be a one-way bet. Conventional analysis, such as the Bank of England's, of why the pound was such a magnet for international investors in 1997 and early 1998 focuses on several factors. First, interest rates in Britain have risen relative to those elsewhere in Europe and, second, market confidence in the euro has yet to be established, so sterling has had a 'safe haven' role. In addition, markets tend to overshoot. If dealers are buying the pound, they carry on doing so, even when it rises above levels they would have considered likely - it becomes overvalued. Like stretching a piece of elastic, the risk is of a very sharp reversal.

Assessing how much the markets will overshoot is a mug's game for forecasters but the first two factors are more predictable. We knew strength of demand in the economy would require higher interest rates, even if the Bank of England had not been granted independence. We also knew, once it was plain that the euro would start life as a 'wide currency' grouping, that the money movers would take time to get used to it. The question then is whether there has been some x-factor behind sterling's strength - I think there has.

Cast your mind back just over a year ago. Many predicted that if the Labour party was elected to government, it would soon run into economic difficulties, most notably from a challenge to its public spending plans by the relevant unions. There was also concern that the benign 'Goldilocks' economy of the first half of 1997 - not too hot and not too cold - would give way to something more dangerous, with a big acceleration in pay settlements across the board and a sharply widening trade deficit.

Labour confounds the critics

In fact, the labour market has been surprisingly moderate. Exports are clearly under severe strain but the promised deterioration in Britain's trade position has been slow to feed through. In 1997, for example, a current account surplus was recorded. More importantly, the Government has been a model of fiscal probity. This is where most of the analysts have got it wrong. They claim that Gordon Brown should have raised taxes more significantly in his July 1997 and March 1998 budgets, targeting consumers directly. This, they say, would have eased pressure on the Bank to raise interest rates and so limited sterling's rise.

But just suppose Brown had been tougher. The markets, already getting used to a chancellor demonstrating fiscal probity, would have got more of the same. Sterling could easily have risen even further. The best way for him to have pushed sterling lower would have been to make a dog's dinner out of public spending and taxation, and lose control of the budget deficit. He has done neither.

Rising confidence in the UK

Part of the x-factor is that the pound has risen because of increased international confidence in Britain - thanks to the Government's, perhaps surprisingly, prudent stewardship of the economy. Coming on top of measures taken by the previous government to boost the economy's underlying performance, we should take this x-factor seriously. But how much of the pound's recent performance is related to this x-factor and how much reflects those other, presumably temporary, factors?

Not too long ago, it was common to regard the sustainable level for the pound against the Deutschmark at something like DM2.40 and DM2.50, and for the sterling index with a base date of 1990 (when it equalled 100) as around 90. But these figures did not build in any x-factor. With the x-factor, I believe 'fair' value for the pound has risen to between DM2.70 and DM2.90, and between 95 and 100 on the index.

This has serious implications. It means that, while business should look for a lower pound, and one that probably overshoots on its way down, it should not expect one that is too low. It also has implications for European economic and monetary union. For anyone who thinks that France and Italy will permit sterling to enter the euro at the equivalent of an exchange rate of DM2.50 is in for a shock.

Find this article useful?

Get more great articles like this in your inbox every lunchtime

When spying on your staff backfires

As Barclays' recently-scrapped tracking software shows, snooping on your colleagues is never a good idea....

A CEO’s guide to smart decision-making

You spend enough time doing it, but have you ever thought about how you do...

What Tinder can teach you about recruitment

How to make sure top talent swipes right on your business.

An Orwellian nightmare for mice: Pest control in the digital age

Case study: Rentokil’s smart mouse traps use real-time surveillance, transforming the company’s service offer.

Public failure can be the best thing that happens to you

But too often businesses stigmatise it.

Andrew Strauss: Leadership lessons from an international cricket captain

"It's more important to make the decision right than make the right decision."