Over recent weeks movements in foreign exchange markets have marked something of a change in the global economic climate.
Depending on your way of viewing currency movements, the US dollar has depreciated against the euro or the euro has appreciated against the US dollar. And sterling has moved with the dollar, although not as sharply.
This depreciation in sterling was one item mentioned by the Bank of England’s Monetary Policy Committee (MPC) in its decision to hold base rates at 3.75% in its meeting at the beginning of May. One of the key concerns among some of the members of the Committee was that the global currency movements could lead to higher inflationary pressures in the UK in the medium term.
This effect could perhaps be caused directly from higher input prices, or indirectly from any boost to production levels at a time when unemployment is at a relatively low level.
Of course, global currency movements can be erratic. If the depreciation were to be reversed quickly then those concerns would lessen. If the overall economic picture remained unchanged the discussion of a possible bank base rate reduction would move forward on the agenda, which could obviously then impact on UK mortgage rates.
The euro has strengthened significantly on foreign exchange markets in the past two months. This rally has occurred despite eurozone economic growth data being even weaker than expected. Against the US dollar, the euro has risen by some 10% since mid March.
The rise against sterling has been less pronounced, but has nonetheless contributed towards the 3% fall in the sterling trade weighted index over the past two months. The depreciation of sterling appeared to have played a key role in the decision of the Bank of England’s MPC to leave the base rate unchanged at the May meeting.
It is significant that the MPC vote was split 5-4, with the five Bank of England members voting for no change, while the four independent members voted for a 0.25% base rate reduction. The Bank of England economic model attaches a significant degree of importance to exchange rate movements, via the impact both on growth and inflation.
A fall in the sterling exchange rate is perceived as a stimulus to the economy: it also feeds through into inflation, subject to a time lag. A high proportion of UK consumer goods is imported. Underlying inflation (RPIX) currently stands at 3%. The Bank Of England’s MPC members clearly felt that there was a risk of inflation rising to the upper end of the target had base rate been reduced.
It is quite feasible that euro base rate will be reduced on 5 June ‘ the day of the next MPC meeting, thus providing a window of opportunity to reduce UK base rates. Recent weak UK retail sales data would certainly provide support for a further base rate cut. Whether the Bank of England does reduce base rate by 0.25% on 5 June may well depend both on the euro base rate decision, and on currency market movements over the next few days. The 5 June meeting is likely to be another very close call.
On balance, I believe that the MPC will keep base rates on hold, at least until there are clear signs that sterling is stabilising on foreign exchange markets
Longer term fixed and capped rates are subject to a wide range of domestic and international factors. While international base rate prospects are the prime driver of two-year rates, longer term fixed and capped rates, especially five-years plus are determined more by movements in US bond markets.
By 9 June we will know whether or not Gordon Brown believes the UK economy meets his five economic tests. The jury is out but the money seems to be on no, almost certainly qualified with not yet.
Whether or not Brown gives a thumbs-up to the euro, we have to consider what effects the external pressures of euroland have on the UK mortgage market.
The recent strength of the euro against sterling and the US dollar has raised fears of deflation in Europe with some commentators criticising the ECB’s failure to look beyond controlling inflation. This approach potentially undermines the growth needed within economies.
The devolution of monetary policy to the Bank of England has seen a sustained period of lower interest rates and stable low inflation in the UK. Combined with the Government’s fiscal policy this has laid the foundations for relatively steady economic growth. Achieving this, and maintaining it, must be the Holy Grail for any finance Minister.
The relative strength of our economy has underpinned sustained growth in house prices and lending, providing some of the best years our industry has seen. We now have the most competitive market in Europe, but the drive to join the euro could change that.
The historic cyclical nature of the UK housing market does not fit with the stability model Brown has in his view of the economy. The suggestion is that we need to move to a more European/American model of long fixed rate products.
The idea of an intrinsic change to the UK mortgage market in order to achieve convergence in itself would seem to reduce opportunities for UK lenders to expand into the new European market. In so doing, would Brown ensure we fail to meet one of his own tests, impact on the UK financial services industry?