If the publication of the Bank of England’s August quarterly Inflation Report halted the upward trend in the Pound against the Euro, highlighting the country’s negative economic and inflation outlook, Governor Mervyn King’s speech to lawmakers last week contributed to further depressing the UK currency. King said that the Bank of England may soon decide to cut the deposit rate (i.e. the rate at which the liquidity that commercial banks deposit with the Central Bank is remunerated), which now stands at 0.5%. Some economists advanced the hypothesis that the UK will likely adopt the negative rate policy first implemented by Sweden’s Riksbank in July. Nevertheless, the chances of this happening look slim (the BoE's next Monetary Policy Committee Meeting is scheduled for 8 October).
Overall, King's words have intensified fears about the British economy over the coming months, indicating that the monetary policy may remain accommodative for a long time. "The strength and sustainability of the recovery is still very uncertain and the balance of risks to the inflation target of 2% remains downward" said King.
Governor King did not appear to be worried about the country’s short-term economic prospect (the inflation report suggested that a short-term rebound in economic activity is "inevitable" due to the strong expansionary policies pursued by the whole of international central banks and governments), but about the medium-term outlook, as recovering the ground lost during the crisis that hit the country over the past two years will not be easy task.
A harmful signal on the economic outlook came from a report recently published by Ernst & Young Item Club. According to the study, housing prices should fall during the first half of 2010 despite recent signs of improvement, then stabilise in the following two years and subsequently start picking up as the wider economy strengthens and credit conditions ease. But the 2007 record high prices should not be achieved before 5 years.
The sharp rise in unemployment, which climbed to the highest since 1995, will continue to weigh on the real estate sector and on the economy as a whole, and will trigger an increase in the savings ratio due to growing concerns about the labour market outlook. With government spending likely to be put under control in the near future in the face of the large deficits expected for 2009 and 2010, exports appear to be the only hope for a return to growth. Considering also that deflationary pressures are much feared by UK central bankers, a further weakening of the Pound would be welcomed by the BoE, as we stressed in the article published last August 15.
Last week the Euro/Pound exchange rate marked the 0.9 level for the first time since May (+3%). Leading international bank strategists expect this trend to persist into the coming months. As an example, Hans-Guenter Redeker, a currency strategist at BNParibas, has recently set his Euro/Pound target price at 1, while Steve Barrow, a currency strategist at Standard Bank, has set a target price of 0.95. As in the case of the US Dollar, the main reason for the decline in the Pound is the change of its role during carry trade operations - from investment to financing currency due to low interest rates. With the monetary policy expected to remain expansionary in the UK much longer than in other major western economies and with the Pound unable to act as a safe haven currency during fly-to-safety phases, the British currency is to be preferred to the US Dollar in carry trade operations despite slightly higher interest rates. The Pound is likely to stay weak in the foreseeable future.