Cheaper sterling to the rescue?

For some time now I have been arguing that the media should be paying more attention to the exchange rate when considering the propsects for the UK economy over the coming months.

A cheaper currency acts as a boost to exports and aggregate demand and can be a very useful stabiliser in an economy weakening from the fall-out from the credit crunch. There are naturally risks from a sharp downward movement in the exchange rate, not least the impact on the prices of imported products and possible flow-through effects on cost and price inflation.

But taken as a whole, a lower exchange rate is what the UK economy needs at the moment - and we are getting it! Charles Bean, Chief Economist of the Bank of England made clear reference to this in an important speech in London today - it is available to download here from the Bank of England website. I have picked out one paragraph in particular which focuses on the exchange rate and compares the impact of cuts in interest rates with currency depreciations.

A major development since the beginning of August 2007 has been a 12% fall in the effective exchange rate for sterling – the value of sterling compared with a basket of currencies, weighted by their relative importance in our international trade. That will provide a fillip to net exports, though it will tend to push up import costs too. Broadly speaking, the fall is of the same order as the depreciation after our exit from the Exchange Rate Mechanism back in September 1992.

Economists sometimes used to use a rule of thumb that a one percentage point fall in sterling had the same effect on output as a ¼ percentage point cut in interest rates. Now the impact of a change in the exchange rate will depend on what caused it and whether it is expected to persist but, at least according to this crude yardstick, the stimulus from the fall in sterling would be roughly equivalent to a cut in interest rates of three percentage points. That should go some way to offsetting the contractionary impact of the dislocation in credit markets, as well as generating a more sustainable composition of demand and a much-needed reduction in the UK’s current account deficit.

The rest of the article is here - click on 17th April and the speech entitled “Walking the Tightrope”