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Is the British Economy Slowing or Stagflating?

Is the British Economy Slowing or Stagflating?

2011-05-27 19:33:00
Christopher Vecchio, CFA, Sr. Currency Strategist
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Wednesday’s report issued by the Office for National Statistics confirmed an initial reading of British growth, saying that the United Kingdom’s economy grew at a 0.5 percent rate in the first quarter, and grew by 1.8 percent on a year-over-year basis. The response by the Pound was to rally against the U.S. Dollar for the ensuing three days, gaining approximately 1.15 percent in the process. In fact, the Pound has gained 5.16 percent against the U.S. Dollar this year so far. The underlying question lingers, however: is the British economy strong enough to justify a strong Sterling?

A simple glance over the aggregate GDP figure suggests so; 1.8 percent year-over-year growth is modest, especially in a time when the world economy is still struggling to find itself on solid footing and many developed nations are dealing with low rates of growth and high inflation. However, on second glance, looking over the underlying components of GDP, the 0.5 percent quarter-over-quarter growth rate is not as sanguine.

While exports rose 3.7 percent in the first quarter, this was due to a weaker Sterling relative to its European counterparts: the Franc has risen 3.91 percent against the Sterling, while the Euro has risen 1.13 percent against the British currency thus far in 2011. The other components were exceptionally disappointing on the other hand: consumer spending dropped by 0.6 percent, while investment fell by 4.4 percent in the first quarter, and was down 2.7 percent.

Even so, with the 0.5 percent positive reading for growth in the first quarter, unemployment and inflation remain a concern. The March 2011 unemployment rate was the lowest rate since August 2010, at 7.7 percent. Even so, unemployment has been above 7.7 percent every month since June 2009. And, with the high unemployment, has come a rate of inflation that has been steadily increasing since June 2010. The most recent reading in April showed a 4.5 percent rate of inflation.

Even some Bank of England policymakers have doubted the resiliency of the British economy in recent days. In fact, Chief Economist Spencer Dale noted today that the next year or two will be “relatively bleak” for the United Kingdom, and that further Sterling weakness should help “support rebalancing.” Finally, he noted that he’s worried that growth may stay “feeble,” with inflation “high.” With fellow policymaker Andrew Sentance, an interest rate hawk, ready to leave the central bank next week, those on the side of raising the key interest rate in order to control inflation are thinning out.

Going forward, it is looking increasingly likely that the Bank of England will be keeping rates on hold for some time, in order to stoke growth. The number of basis points priced in over the next 12-months for the Pound has dipped to 35.7-bps, as other central banks have already (European Central Bank) or are readying (perhaps the Federal Reserve) to begin to wind-down stimulus and raise their key interest rate, which, according to interest rate differential theory, would put other currencies in favor against the Sterling.

A weaker Sterling might be what the British economy needs, however. By further boosting exports, further investment could enter the country in order to help manufacturers meet foreign demand for British goods. It remains to be seen whether or not the Bank of England will definitely keep rates on hold, but for now, as the economy continues to slow, and inflation remains high, the outlook for the British economy does indeed, as the Bank of England’s Dale noted, look “relatively bleak.” If the Bank of England does leave rates depressed for some time, the Sterling would likely continue to sink further against its European counterparts, the Euro and the Swiss Franc.

Written by Christopher Vecchio, Currency Analyst

To contact the author of this report, please send inquiries to: cvecchio@dailyfx.com

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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