Why the UK needs clarity on Brexit to stop the exchange rate being a source of an economic shock rather than the adjustment tool it is supposed to be
Seven months after the vote for the UK to relinquish its membership of the European Union, the country is still not clear on the direction it will take and hence its long term economic future. Naturally, negotiations which will take place after the end of March 2017 will dictate the country’s direction but if negotiations are prolonged with no clear outcome, then investors will continue to hold more foreign currency than British pounds, and the currency will stay low for the foreseeable future. But why is this a negative point and how does the exchange rate then become a source of shock?
The answer lies in the fact that the exchange rate is reputed to be the adjustment mechanism which stabilises in the wake of imbalances, but as far as Brexit is concerned, the UK is experiencing a new economic landscape. After the vote in June, the exchange rate fell to its lowest level for 31 years but in previous times, the exchange rate would naturally adjust. For example, UK exports would become cheaper, British businesses would be able to manufacture and sell goods abroad, employment would increase and as a result of improved domestic demand, interest rates would rise as inflation (led by demand) increased, and so on. In this case, the exchange rate pass-through effect will raise the cost of production whereby the price of raw materials become more expensive and are passed on to products, simple stated – inflation.
The UK is still able to adjust the rate of interest as another policy tool to control the advent of inflation, however, this simply is not a viable option at this stage. Inflation in this case has occurred as a result of cost-push effects rather than the converse known as demand-pull. Therefore, neither is an increase in the cost of borrowing a viable option to reduce the effects of inflation nor is it a viable option to invite investors to switch back to sterling rather than foreign currency in an attempt to appreciate the currency. Therefore, rather that acting as a stabiliser, the exchange rate will act as an economic shock in itself, and in this case, a prolonged economic shock whereby UK policy in interest rate adjustments in the right direction are no longer possible and inflation creeps through the target of 2 percent with less adequate policies for adjustment.
What is needed now are firm assurances on numerous aspects of not only trade between the UK and the EU, but also the restrictions on personnel through borders. As long as the negotiations appear to lack clarity, exchange rate investors will refrain from holding sterling. If the contrary is a so-called ‘soft Brexit’ rather than a hard one, and the dialogue between Britain and the EU is progressive, then the exchange rate will adjust to levels where the pass-through effect lessens and the UK government can return to and apply appropriate policy, thereby lessening the prospects of a prolonged exchange rate economic shock.
Dr. Victor Chukwuemeka
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