How the Plunging Pound Could Affect the U.K. Economy

(Bloomberg) -- There’s not much good economic news for the U.K. in the pound’s recent collapse.

The currency’s decline to a two-year low won’t take long to have its effects felt. But it may not provide the traditional boost to exports as it fans inflation by lifting import costs. It will dent worker’s real incomes and affect the Bank of England’s outlook for interest rates when it presents new forecasts on Thursday.

Here are the ways the currency affects the economy.

Exports

If recent history is any guide, the pound’s latest slump is unlikely to provide a fillip to U.K. exporters. Sterling’s decline after the 2016 Brexit referendum created what BOE Deputy Governor Ben Broadbent called a “sweet spot” for exporters -- a weaker currency even though trade arrangements with the EU hadn’t changed.

For more insight from Bloomberg Economics, click here

But there was little sign of a trade boost. The best period was 2017 -- a year the global economy boomed -- but the years on either side saw a net drag from trade. Cumulatively since the EU referendum, it’s been a negative.

Now that world growth -- and trade in particular -- looks to be in a downturn, reaping the benefits of the currency’s depreciation will be even harder.

“In a difficult global backdrop, a weaker pound is clearly not going to be helpful for manufacturers,” said Victoria Clarke, an economist at Investec.

One positive offset might be on prices, particularly if the U.K. export markets put tariffs on British goods after Brexit. Companies could cut prices and count on positive currency effects to lift the bottom line once they bring the profit from foreign sales home.

Imports

For every effect on export prices, there’s an opposite one on import costs. The U.K. buys about 230 billion pounds ($280 billion) of goods from the euro area, almost 50% of its total needs in 2018. Sterling has fallen 6% against the euro since the BOE’s last Inflation Report in early May.

For businesses, that means it costs more to bring in the raw materials they need. Persistently higher expenses could force firms to rethink their investments in the U.K., which could mean cutbacks, job losses or, in the extreme, shifting production elsewhere.

Inflation

There’s also fallout for consumers. After the pound’s decline in 2016, inflation accelerated in 2017, breaking through 3% that year. It’s far from hyperinflation, but with wage growth only slowly picking up, that puts pressure on earnings. The U.K. has only recently come out of a period of negative real-income growth; another inflation spike could see that return.

Bank of England

Governor Mark Carney and fellow policy makers already have a tricky communication task, as their forecasts are based on an assumption of a form of smooth Brexit. That’s put them completely at odds with markets, and the gap is widening.

What Bloomberg’s Economists Say...

“The forecast has become useless as a communication device.”
--Dan Hanson, economist. Click here for the full INSIGHT

A jump in inflation should mean a more hawkish BOE. But the economic uncertainty surrounding Brexit -- as well as the global economy -- means weaker business investment and consumption, pointing to a more dovish stance.

The central bank has looked through temporary inflation spikes before. The irony of a dovish stance is that it could weaken the pound further, adding to potential upward pressure on inflation if the move proves sustained. That would pile on the complications for the BOE.

--With assistance from Jill Ward.

To contact the reporter on this story: Fergal O'Brien in Zurich at fobrien@bloomberg.net

To contact the editors responsible for this story: Craig Stirling at cstirling1@bloomberg.net, Brian Swint, Zoe Schneeweiss

©2019 Bloomberg L.P.