Sterling remains overvalued but is being undermined by UK election uncertainty
- Start of year sterling rally ends
- WPI data shows beneficial deflation
- Energy, Food and Recreation Costs fall
Current Overvaluation of Sterling
Sterling Enters Turbulent Times
The latest set of World Price Index (WPI) data indicates that the United Kingdom Pound still remains overvalued against the US dollar by 10% in Purchasing Power Parity (PPP) terms, but this is being eroded by a number of factors that could push the relative value of the currency down in coming months.
World Price Index Methodology Explained
The methodology behind the WPI involves collecting price data for a representative basket of goods across different countries. This allows the measurement of the real purchasing value of national currencies across the world in terms of their relative purchasing power against a comparable basket of goods in the US.
The chart opposite shows that from July 2014 until February 2015 Sterling and the Euro both followed a similar valuation path declining rapidly in PPP terms against the US$. In July 2014 the market exchange rate for sterling was US$1.71 against a WPI rate of US$1.39. The Euro was 0.74 as against a WPI rate (based on the WPI average of Germany, France, Italy and Spain) of 0.86. At these exchange rates the Euro was overvalued by 17% against the US$ in PPP terms while the £ was overvalued by 24%.
Since then the £ fell to an overvaluation of 7% by February 2015 and the average value of the Euro fell below PPP parity to hit an undervaluation of 0.03% the same month. The reasons for these currency realignments were twofold: Dollar strength arising from a growing economy and an anticipation of future tightening of monetary policy by the Federal Reserve. (See Chart in PDF)
Euro Weakness and Political Factors
Brexit vs Grexit
The Euro has continued to weaken and has reached an average undervaluation of -3% in April 2015. Easier monetary policy across the Eurozone has been joined by renewed fears of a Greek default and expulsion from the single currency zone to push the Euro down. March saw the start of the European Central Bank’s €1.1 trillion quantitative easing programme to combat deflation within the EU while Greece looks as if it will exhaust its cash reserves by the end of April. Events in Europe meant that for one month Sterling parted company with the Euro with the WPI exchange rate at US$1.38 in March 2015 while the market rate rose to US$1.53 implying that the overvaluation of the British currency rose from 7% to 11% on the month while the average valuation of the Euro fell to an undervaluation of -2% the same month.
From now onwards, the relative value of the UK Pound in PPP terms against the US Dollar and the Euro is almost wholly dominated by the uncertainty surrounding the outcome of the forthcoming UK General Election on May 7. There are a number of political scenarios that are unsettling currency markets. A Conservative victory could result in an In-Out EU Referendum which would leave markets uncertain about the future position of the City and the UK’s attraction as a home for Europe-looking Foreign Direct Investment. In contrast, an outright Labour victory, supported or unsupported by the Scottish National Party threatens to lead to a loss of control over public finances and a loss of confidence in the currency. A hung Parliament with a weak administration would also produce softness in the Sterling exchange rate for some time.
Impact of Inflation on Currency Value
Inflationary Pressures
Whatever the result of the election the value of the currency will be supported in the short-term by falling inflation which raises real Sterling bond yields. The annualised change in the Consumer Price Index fell from 0.5% in December to 0.3% in January to reach 0.0% in February. The Bank of England expects that future falls in the price of energy and foodstuffs will result in deflation of the beneficial kind, raising real incomes without leading to a downward price spiral and a rise in the real value of debt burdens. The central bank concludes that a further loosening of monetary policy is not justified because inflationary pressures in other sectors are beginning to build up.
Breakdown of UK Inflationary Pressures
This picture is supported by a breakdown of WPI data into its component parts which provides an insight into the distribution and impact of these inflationary pressures across the UK. Recent WPI data shows that prices fell more rapidly in the Energy sector year-on-year in April 2015 compared to the year before (-14.2% vs -6.9%) and in Food (-9.6% vs 4.9%). In Recreation prices fell by 12.1% compared to inflation of 5.3% the year before. These deflationary pressures are countered, however, by the opposite pattern of price changes in the Hospitality sector (-3.2% vs -6.9%) and in Durable Goods (+2.0% vs -25%). (See Chart in PDF).
