Fall in sterling could derail UK’s recovery

A COLLAPSE in the value of sterling in the wake of the general election would push inflation even higher and could even risk derailing the economic recovery if the Monetary Policy Committee (MPC) is forced to tighten policy too soon, a top City consultancy will say today.

While policymakers have welcomed a weaker sterling because of its supposed positive impact on net trade, Fathom Financial Consultancy reckons that the boost to growth via net trade has been minimal to date.

In its quarterly economic forecast, it suggested we will only see a limited impact on trade and highlighted the inflationary impact of the nominal decline in the pound: “Sterling has so far proved to be a more inflationary and less expansionary influence than most, including the MPC, expected it would be.”

Another sharp fall in sterling could therefore boost inflation beyond March’s above-consensus 3.4 per cent.

Fathom warned that the MPC could be forced to raise short-term rates to defend its inflation credibility. That could choke off the economic recovery, which would further exacerbate the fiscal problem.

In its opinion, the safest bulwark against this risk would be a credible fiscal retrenchment plan. This could reduce short-term growth by four percentage points, double what current plans currently imply. As a result, its forecast for GDP growth in 2010 is just 0.8 per cent and predicts that it will remain well below trend (about 2.25 per cent) until 2012.

“The lack of honesty among the main parties regarding the true scale of the fiscal problem facing the UK threatens to fatally undermine what is left of sterling’s battered credibility.”

Ideally, monetary policy would need to stay relatively loose to stop the process choking off growth. But with inflation predicted to be at target or above for the full forecast horizon, this may be easier said than done.