Pound foolishness

September 30, 2022 09:06
Bank of England (Photo: Reuters)

After earning my PhD in 1982, I spent the first 20 years of my professional career immersed in the tumultuous world of foreign-exchange markets. Today, current events are bringing back both happy and embarrassing memories.

I learned three things about currencies during that time. First, everyone may get their 15 minutes of fame (the Andy Warhol principle), but they shouldn’t expect it to last any longer than that. The forex market – the world’s biggest fruit and vegetable stall – tends to make idiots of those who think they’ve found the magic forecasting formula. That points to the second lesson: If I was “right” 60% of the time, I knew I should be content. Finally, floating exchange rates will always go up and down, except for when they are going down and up.

With these lessons in mind, the British pound’s current gyrations point to some other essential traits of currency markets. First, the pound’s sudden weakness comes at a time when the US dollar has grown extremely strong against all currencies, owing to markets’ belief that the US Federal Reserve will do whatever it takes to reduce inflation. Some currencies, such as the Japanese yen, have fallen even more than the pound so far this year. When inflation starts to ease and markets perceive that the Fed is done tightening, some of these developments will probably reverse.

Second, governments that adopt surprising and unconventional policies should not be surprised to see their countries’ currencies weaken. British Prime Minister Liz Truss’s head-scratching decision to slash taxes and embark on a massive borrowing spree is a case in point.

I used to think of countries’ policy mixes in the context of four alternatives, which I would illustrate with a four-quadrant diagram. The top left square included only those countries that had both tight monetary and tight fiscal policies. Switzerland, with its franc, was the typical example; and the pre-European Monetary Union (EMU) Deutsche Mark would also often fall into this (sparsely populated) quadrant.

The top right corner held countries with tight fiscal policies but easy monetary policies. There were never persistent examples here, but most post-EMU euro members would qualify. It is worth remembering that the euro weakened during its early years, a dynamic that also could be used to describe the pound under Prime Minister David Cameron’s pre-Brexit coalition.

In the bottom right were currencies of countries with easy fiscal and monetary policies, including many emerging-market economies. A notorious example was the Brazilian real, but the pre-EMU Italian lira also fell into this corner.

Finally, the bottom left quadrant represented a combination of tight monetary and easy fiscal policies. A good example was Reagan-era America, which maintained a peculiar and unstable mix of highly expansive fiscal policies, ultra-tight monetary policy under Fed Chair Paul Volcker, and a very strong dollar.

As it happens, the last 12 months of Joe Biden’s presidency have been marked by a similar mix. The dollar is now highly overvalued – at least according to the standard valuation criteria – and one must wonder when some holders might start to sell (remember rule number three above). One final lesson from my days in the currency-market trenches is always to be very cautious about buying into the consensus view, especially when currencies are significantly misaligned.

Where does all this leave the pound? First, it is extremely undervalued against an overvalued dollar. If you believe that the UK, the US, and others will eventually get inflation back down toward the target rate, the scene is already set for a big reversal. The pound’s fair value against the dollar is probably around $1.40-1.45. But it is likely to weaken further until the forces (on both sides of the Atlantic) that have driven it so far from this equilibrium subside or change direction.

Crucially, financial markets now perceive the UK to be in the bottom right quadrant – the domain of the old Brazilian real and Italian lira. Part of the problem is that the Bank of England has been relatively timid so far. Even though it started to raise rates before many of its peers, its hikes have repeatedly been more dovish than expected, including – ironically – on the day just before Truss unveiled her ill-fated “mini-budget.”

I am not alone in believing that short-term interest rates in the UK have been too low for too long, and that the BOE now will have to accelerate its pace of tightening toward 4-5%, even if that means borrowers must suffer. If it can muster the will to do that, markets at least might conclude that the UK is migrating over to the bottom left (Reaganomics) quadrant.

Fiscal policy thus remains the key variable. I am all for new, disruptive economic thinking, especially if policymakers have compelling ideas for addressing the chronic problem of weak productivity growth. I myself made the case for a more ambitious productivity-enhancing framework (alongside a tighter monetary policy) in testimony to the UK Treasury Select Committee earlier this year.

But the Truss government’s plans are not at all what I had in mind. In fact, I am not sure what to make of Trussonomics. The government’s claims about what its supply-side reforms will achieve lack credibility. For example, we already know that corporate tax cuts over the last 20 years have simply boosted companies’ balance sheets and profits, not investment. What purports to be a bold program to ward off recession and lay the foundations for stronger productivity growth appears to be a traditional Keynesian fiscal expansion aimed at rewarding the well-off and the Conservative Party members who voted for Truss to become Tory leader, and thus prime minister.

I have no axe to grind with Truss or her chancellor of the exchequer, Kwasi Kwarteng. But, to have any chance of surviving in office and boosting the UK’s growth potential, they urgently need to articulate a credible plan.

As for the pound, it is probably a buy, but only for the brave and deep-pocketed.

Copyright: Project Syndicate
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Jim O’Neill, a former chairman of Goldman Sachs Asset Management and a former UK Treasury Minister, is Chair of Chatham House.

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