Thursday, October 21, 2010

British Fiscal Austerity Will Weaken Pound

The new British government have announced a far reaching fiscal austerity program. Given that the current deficit levels are unsustainable and unhealthy, that is mostly a good thing. However, as Britain -like for example Germany, the United States and Japan- has a "safe haven" status, the benefits will be smaller than they would have been in countries perceived as risky like for example Greece, Spain or Ukraine. Furthermore, the tax increases -as well as one spending cut- will have a negative supply side effect.

But leaving aside the issue of the effect on economic growth, how will this impact the pound's exchange rate?

Well, it will in short lower it. Even assuming that it has no effect on Bank of England monetary policy, a lower deficit will lower interest rates and so lower demand for pound assets.

To the extent it might provoke the Bank of England into further "quantitative easing", the negative effect on the pound's exchange rate will of cource be even greater.

This doesn't necessarily mean that the pound will depreciate in value in the near future compared to its current exchange rate, as traders might have already priced in these effects. What it clearly does mean however is that the value of the pound will be lower than if there hadn't been any fiscal austerity program.