- The UK current account deficit is 2.7% of GDP and the Budget deficit is 4.8% – raising fears of a 1976-style currency crisis.
- Sterling will be a barometer on Rachel Reeves’s ability to balance the need for fiscal prudence, economic growth and honouring political pledges.
- On 8 October 1992 Britain started using an inflation target. This proved to be a turning point in the long-term decline in the pound.
Robert Farago, head of strategic asset allocation, Hargreaves Lansdown:
“Currency markets aren’t tranquil places, and it’s hard to accurately chart their direction or how comfortable the ride will be. The current account deficit and the Budget deficit will be raising concerns that history could repeat itself in the coming months, precipitating a 1976-style currency crisis. But for real perspective, you need to go a bit further back in history.
Calm on the currency markets is always relative. Nobody would argue that a 10% drop in the value of sterling on the back of the Brexit vote in 2016 was plain sailing. However, compared to what came before, the past 30-odd years have been relatively uneventful. This hasn’t been an accident, it’s the result of a change in policy and the introduction of inflation targeting.
Prior to this was a century marked by crises. Underlying weakness in the currency over this period was caused by a fundamental shift in the UK’s role in the world economy. As the UK shrank as a share of the global economy, central banks sold out of the pound. It began a long-term decline in 1931 and hit an all-time low against the dollar in 1985.
Two dramatic crises during this period were linked to the fact that in an effort to stop currencies fluctuating against one another, they were pegged to a common asset – first the gold standard and then the European Exchange Rate Mechanism (ERM). Unfortunately, in both cases, sterling was pegged at too high a rate, which put the economy under too much pressure, causing the link to fail, and huge drops in the value of sterling.
On 8 October 1992 Britain started using an inflation target. This proved to be a turning point.
What is inflation targeting?
In the aftermath of Black Wednesday, instead of linking to a different currency, the UK adopted inflation targeting. This is where monetary tools and strategy are used to try and maintain price stability. A wave of countries across the western world have taken this approach, which has led to a convergence in both inflation rates and interest rates. They’re both key drivers of currency movements, so this has reduced volatility in currency fluctuations.
Why is there talk of a 1976-style crisis?
Today, the UK twin current account and budget deficits have led to fears of a 1976-style crisis. But there are major concerns about government borrowing across the developed world – and currencies are a relative thing.
The inflation targeting regime has changed over time. When prices soar, rates will rise to restore both the rate of inflation and inflation expectations. However, unlike under the gold standard or the ERM, the UK no longer tries to engineer a drop in prices after a burst of inflation. This makes the currency less vulnerable to speculation.
If there was a crisis, an IMF programme today would undoubtedly recommend a hike in at least one of the big three taxes, breaking a manifesto promise. Sterling will be a barometer on Rachel Reeves’s ability to balance the need for fiscal prudence, economic growth and honouring political pledges. Without tax hikes to balance the books, sterling is likely to suffer.
Valuations matter over the long term, much less so over one year. Today, the US dollar is overvalued against sterling, the euro and the yen. But this is a minor ingredient in the recent weakness of the dollar, which has largely been driven by the significant shifts in US policies.
If this summary of our thinking on sterling leaves you unclear on its direction, you’ve read it right. Currency markets are inherently hard to predict. From 1925 to 1985, the pound was a one-way bet. The introduction of an inflation target was an important ingredient in breaking this downward spiral. Today, we do not see a major valuation imbalance, interest rate disparity or difference in economic outlook that makes sterling stand out – one way or the other.
Sterling: a timeline
1717: Master of the Mint, Sir Isaac Newton, introduced an upper limit of the value of gold relative to silver that, de facto, meant that the pound had slipped onto the gold standard at 3 pounds, 17 shillings and 10.5 pence per ounce. Gold would remain at this price – bar a break during the Napoleonic wars – until the start of World War I.
1925: New York took the title of the world’s largest city from London. Around this time, the US dollar overtook sterling as the leading reserve currency. The UK’s role as a financial centre was under threat. Winston Churchill, Chancellor of the Exchequer, announced a return to the gold standard.
1931: Sterling was widely believed to be overvalued at this level and a period of austerity followed to bring about the deflation necessary to protect Britain’s gold reserves. By September 1931, in the midst of the Great Depression, the pain proved too severe. Britain abandoned the gold fix, with sterling plunging by around 30%.
1976: Jim Callahan’s Labour government were facing another currency crisis, due to twin current deficits: Britain was spending more overseas than it was earning; and the government was spending more than it was receiving in tax revenues. Chancellor of the Exchequer, Denis Healey was forced to call on the IMF for financial assistance.
1985: Finance ministers and central bankers from the US, UK, Germany, France and Japan met at the Plaza Hotel in New York and agreed to intervene to reverse a period of excessive strength in the US dollar. This policy – the Plaza Accord – was highly successful in weakening the dollar. 1985 marked the all-time low for the pound against the dollar.
1990: Britain joined the European Exchange Rate Mechanism (ERM) a decade after it’s eight founding members, but at too high an exchange rate. Inflation was above that in Germany, the country that effectively set rates for the whole system, so economic imbalances rose and
1992: The markets – and George Soros in particular – sniffed an opportunity. When the pound came under pressure, the Chancellor of the Exchequer Norman Lamont raised rates to 12%, then 15%, before abandoning the ERM – all in one day. Once again, the pound plunged.
1997: On 6 May 1997, four days after the Labour party ended 18 years of Conservative party rule, Chancellor Gordon Brown announced the independence of the Bank of England.
2016: On 23 June 2016, Britain voted to leave the European Union. Sterling dropped 10% overnight, the largest single-day fall in over 30 years.”
