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Sterling and Inflation 13/03/2009

Posted by chrisdshaw in Economics, FX.
Not my own work- but an interesting analysis by Stumbling and Mumbling on the effect of a falling GBP on prospects for inflation. This ties in with my view that we should be a little more sanguine about the UK economy, particularly as a relative FX play.
“””””” DeAnne Julius and Danny Gabay say something I find surprising:
The UK and its currency are now perceived as a riskier bet. Sterling’s decline may be telling us that overseas investors see a significant risk of inflation ahead. How come? 
If sterling’s really fall is telling us that there’s a risk of inflation, then it should have been accompanied by a rise in the breakeven inflation rate (the gap between conventional and index-linked gilt yields). But my chart shows that the opposite has happened. As the pound has fallen, investors have become less worried by inflation, not more.Beirtwi 
Now of course, it might be that the breakeven inflation rate is set mainly by domestic investors, and foreigners know something we don’t. But as there’s little evidence that foreign investors are better informed than local ones, this is improbable.
This doesn’t mean Julius and Gabay are wholly wrong, though. They’re dead right to say that sterling has become riskier. Evidence for this is that the rough pattern of sterling – a slump in the autumn, a weak mini-recovery in January-February and a fall earlier this month – is the same as global share prices. Changes in appetite for risk, as measured by changes in share prices, are accompanied by changes in sterling. 
One reason for this might be that, as they say, investors don’t want to put money into economies dependent upon financial services, and stock market moves are a barometer of confidence in financial services.
Another reason is that sterling was buoyed up in the early 00s by carry trades – borrowing yen and Swiss francs to buy higher-yielding currencies like sterling. But the same liquidity crunch that hit shares also forced an unwinding of these trades, with the result that sterling fell and the yen and Swissie soared. The same crunch also caused fears of deep recession which have cut inflation expectations. 
For this reason, I share Duncan’s relaxed view of sterling’s fall. It’s a symptom of a global problem, not a UK one. 
There’s a simple test of this. If I’m right, then if (and it’s a big if) stock markets continue their recovery of the last few days, sterling too could recover.
It’s if this doesn’t happen that I’ll start worrying a little.  “””””


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