what's likely to happen to the value of the pound over next few years? What'd happen if there was a crash in the housing market, for example? Or if the dollar continued to drop?
Firstly: Factors that influence Exchange Rates
1. Interest Rates
2. Competitiveness of British Goods
3. Confidence / expectations of investors
Factors that influence Forecast for Pound Sterling
- House Price Crash? - It is quite likely there could be a fall in house prices. If this was to occur we would see a significant fall in consumer spending growth. This lower spending would reduce inflationary pressures and enable the MPC to cut interest rates. Lower Interest rates could reduce the value of the pound. (less people want to save in UK banks)
- Continued Weakness of the Dollar - It the dollar depreciates further against the pound - which is quite likely, the pound will continue to rise against the dollar, but, our main trading partner is the EU. Therefore, the key question is will the Pound rise or fall against the EURO (66% of trade is with EU, 16% with US)
- The Pound is Overvalued - According to the Big Mac index the Pound is at least 21% overvalued against the US dollar. The Big Mac reflects purchasing power parity and this shows that the strength of the pound has meant that British goods are more expensive. - Just go to America and see how much cheaper electronic goods are.
- However, the Big Mac index is a very poor guide to future currency movements. Currencies can often remain overvalued permanently. For example, the Yen has been overvalued for several years.
- Comparison with Other Countries - 2008 could see UK interest rates fall, however, if European and US interest rates fall by the same rate there will be no downward pressure on the Pound.
- Balance of Payments - Current account deficit in the UK is about 3%. A large current account deficit can contribute to a devaluation. - The US deficit is 6% of GDP and is a factor in the dollar's devaluation
- Market Sentiment - This one is very difficult to predict. Generally, the Pound has been seen as a reasonable investment. The UK economy is doing relatively well and we have a good record of low inflationary growth. I can't see this changing fundamentally.
I think it is likely that the pound will remain overvalued on PPP measures such as the Big Mac Index. The UK economy may slow down next year, however, at the moment, I cannot see a serious crash. The slowdown is unlikely to be any more serious than our trading partners. Therefore, the pound will continue to be strong especially against the dollar.