How low can sterling go?

The decision last week by the Bank of England to cut interest rates to 0.25 per cent to offset some of the effects of Brexit caused a large change in currency markets. The Brexit result has caused British purchasing managers’ indices to slide, permanent job placements to fall at their sharpest rate in over seven years, and profit warnings by companies to increase.

Nissan, who famously wrote to the people of Sunderland and explained that most of the cars it made in the Sunderland plant got sold in the EU, only to see the people of Sunderland vote to leave, has announced it won’t be investing more in that plant into the future.

Brexit is real, it is having a real effect on real people, and policymakers across the world are having to deal with it. The person who more than anyone embodied the power of the establishment as the government collapsed in the wake of Brexit was Bank of England governor Mark Carney.

The Bank of England announced a stimulus package last week to ensure monetary policy does its part to help the British economy make it through the worst of Brexit.

There are three main pillars of the stimulus: the first rate cut since 2009, pushing interest rates to the lowest level in the 322 years the bank has been in existence; the purchase of up to £10 billion of British corporate bonds, a new funding scheme to help Britain’s banks push the rate cut through to the real economy as quickly as possible, and a new round of government bond-buying worth £60 billion in under six months. All in all, a very impressive and surprisingly aggressive effort put together by one of the world’s leading central bankers. Carney even hinted strongly at another rate cut in the future.

The effects? Sterling fell relative to the US dollar, British bond yields hit new record lows, and equities bounced back up.

The Bank of England has now bought so many ‘gilt’ bonds it owns over one-third of all the British gilts in existence. The markets are pricing in ultra-loose monetary policy for years to come.

Last week I wrote about Britain’s huge current account deficit, which now stands at nearly 7 per cent of gross domestic product, a historically high level in the post-war period. Essentially, Britain borrows from the world to finance this deficit, which leaves it vulnerable to currency crises, sudden stops, and market panics.

It’s this last one that’s the real problem. The ‘markets’ – and here you can’t think of omnipotent red-braces-wearing old Etonians; think coked-up 26-year-olds – can simply decide Britain is headed for trouble. If enough of them think that, it becomes true, and they refuse to lend to Britain. This sudden halt in capital inflows forces the current account into a balance of payments crisis. Not fun.

The Bank of England is working to reduce the current account deficit to half of this over the next two years amid trade balance improvements and the value of net investment income flows supported by the sharp fall in sterling.

So sterling’s fall – which is making British exports much more competitive, but making its imports much more expensive – should help Britain narrow the difference between the value of what it exports and the value of what it imports. The ultra-loose monetary policy may also reduce inflows of foreign capital a bit, but it also may not.

Monetary policy, in short, is doing its thing. But monetary policy is not enough. Fiscal policy, constrained during the Cameron era by years of austerity, has to be used in a huge way to offset the regime change Brexit will bring about. The May era needs to be defined by an era of capital expenditure and current expenditure increases.

As Mark Carney wrote to new chancellor Philip Hammond: “Many of the adjustments needed to move to that new equilibrium are real in nature, and are not the gift of monetary policymakers.” They are in chancellor Hammond’s gift.

What does all of this mean for Ireland? Only 15 per cent of our exports go to Britain these days. The dramatic movements in sterling will not have helped our exporters at all.

The real question is: how low can sterling go? To answer this question we need to get a little technical and think about exchange rates. Stay with me for one paragraph. I’ll take you to Mordor and back out to the Shire again.

In the short run, the exchange rate between two currencies is determined by market traders responding to differences in interest rates. So as the domestic interest rate falls, thanks to Carney’s rate cut, international investors reposition themselves towards assets denominated in a foreign currency, forcing the spot rate, the rate you see quoted on the news, upwards.

This is what happened last week. In the long run, the currency responds to price differences in each country. That is, it’s all about competitiveness. What I make my stuff for has to be less than what you make your stuff for.

More or less, the rate of appreciation or depreciation of the currency will be approximately equal to the percentage-point difference in the inflation rates of the two countries.

Ireland’s main measure of the level of prices of all new, domestically produced, final goods and services is forecast to still be under 1.3 per cent by 2019. Britain’s just released inflation report estimates the same number for Britain at 1.8 per cent by 2019. If trade with Britain was all Ireland had, then we could expect sterling to fall further relative to the euro. Sterling’s nominal value would fall. This is very bad news for our exporters.

I know I promised you the Shire, but it’s still Mordor in the long run. Sorry about that.