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How the tumbling pound is pushing up prices

pound uk economy sterling inflation interest rate economy
pound uk economy sterling inflation interest rate economy

Chris Vincent is a third-generation wood floorer but he could tell you as much about currency fluctuations and monetary policy as any City analyst. He is constantly monitoring the pound’s exchange rate, hoping that his imported raw materials are billed at the right time.

But with sterling free-falling, there is only the wrong time.

“I’m having many sleepless nights. I keep checking the exchange rate but it’s so unpredictable. It’s all a gamble. If you forward buy, you worry that you’re buying at the wrong rate. It’s really, really difficult,” he says.

Like other companies heavily reliant on imports, the sinking pound has sent input costs surging for Vincent’s £50m wholesaling retailer, V4 Wood Flooring. He buys raw materials anywhere from China to eastern Europe, meaning most of his imports are in dollars and sometimes in euros.

While Vincent has offset some of the costs against falling shipping fees, he has had to pass the rest on.

“You don’t have an option but to put prices up, even if we try to do it by as little as possible. We also need to try to keep our prices stable,” he says.

The energy crisis, a strong dollar and government plans to ramp up borrowing have pushed the pound to record lows against the dollar. It now buys 21pc less in dollars and 6pc less in euros than at the start of the year. Manufacturers like Vincent are the first to feel the hit.

But the costs of the weaker pound will soon filter through to supermarket shelves and high street shops, squeezing already tight household budgets. Economists have different views on how quickly and by how much the depreciating pound pushes up inflation.

Paul Dales, of Capital Economics, says that a one percentage point drop in sterling against a basket of trade-weighted currencies prompts a 0.25 point increase in prices over four years. “The pound is not the biggest driver of the rising inflation but it does make things more expensive than they would otherwise be,” he says.

Sterling has fallen by 10pc since the start of year against trade-weighted currencies, Bank of England data show. Bloomberg’s version of the measure puts the decline at an even steeper 14pc.

This suggests the decline in the pound would add 2.6 to 3.4 points to inflation. Half of the impact from imports on inflation filters through within a year, according to Dales. This means the added costs for households would be £710 to £925 in the next 12 months based on 2022 spending forecasts.

Samuel Tombs of Pantheon Macroeconomics expects a longer lag, however, and cautions that the benefits of last year’s strong sterling are yet to fully materialise. Around a quarter of every pound spent by Britons can be traced to imports, but it varies significantly across individual goods.

Sterling’s weakness will make food and clothes prices rise more than they otherwise would. This will especially affect products such as fruit, vegetables and meat, as around 45pc of these costs come from imports. Car prices are even more sensitive to changes in the exchange rate, with around 60pc of costs related to foreign goods.

Price rises from imports affect all households from poor to rich albeit in different ways, Peter Levell, from the Institute for Fiscal Studies, says. “Those at the lower end of the income distribution are hit harder by the higher cost of imported food and energy, and that accounts for a larger share of their budgets. People at the higher end are hit because they spend more on holidays and luxury goods.”

How hard the tumbling pound will squeeze household budgets hinges on what the Bank of England will do. With the UK likely already in a recession, pulling the levers too aggressively could make the downturn worse. Acting gently will disadvantage the pound.

The Bank’s half point rate rise on Thursday saw some strengthening of sterling but those gains were quickly wiped out by Friday’s mini-Budget leaving the pound in free fall.

“It makes it more likely that they’ll go for faster and larger interest rate rises, because they now have this additional inflationary pressure from the pound,” says Levell. “That would mean it’s not hardship that we would see through higher prices, it’s hardship through higher interest rates. Either way it’s not good news.”

There is no consensus on how long the pound will suffer. This will depend on factors such as the pressures from the energy crisis easing, the dollar weakening and the Monetary Policy Committee’s approach. The Government has signalled there may be more tax cuts to come, which could also spook markets.

Some economists – such as Prof Dennis Novy at the University of Warwick – believe currencies are too unpredictable to meaningfully forecast in the short term. “I might as well flip a coin,” he says.

But he adds that the UK economy faces long-term challenges, which could point to a more permanent hit to the currency. “The UK economy faces headwinds that go back many, many years. The poor productivity and the very poor economic growth go back way before the Brexit referendum. So these are long standing concerns that seem unresolved to this day.”

Most economies are struggling to keep up with the Federal Reserve’s “combination of strong growth and large rate hikes”, Kamakshya Trivedi, of Goldman Sachs, says. He expects the pound to fall to 1.05 in three months and then reach 1.19 a year from now.

Dales also believes the pound and the euro will keep falling, possibly into the middle of next year. They will then bounce back although not all the way, he says. The uncertainty is weighing heavily on businesses that rely on imports. Fhaheen Khan, senior economist at Make UK, says the trade association is already seeing increasing inquiries from manufacturers asking what will happen to the pound.

“Because of the volatility of the exchange rate, it’s becoming significantly more difficult for suppliers and customers to agree on contracts. Some customers are asking for guarantees that if the exchange rate were to get even worse, they will still be able to benefit. The suppliers don’t want to provide that guarantee because they know that it’s so uncertain,” he says.

Over half of UK imports and exports are bought and sold to countries outside the EU. For many of these transactions, the dollar is the dominant currency. Some 61pc of non-EU imports were bought in dollars last year, amounting to £173bn. This means that even a moderate sway in the exchange rate can send ripples through the economy.

While a lower pound harms importers, it usually helps exporters who become more attractive to foreign buyers. But for the UK, this benefit is waning. Only 30pc of exports to non-EU countries were sold in pounds last year – down from 52pc in 2014.

The expensive greenback now accounts for approaching half of non-EU exports, up from a third. While a greater proportion of exports to the EU are sold in pounds they still only make up 36pc.

“Of course if you have a depreciation in principle that can be good news for your exports, which become more competitive. But it’s not as simple as that,” Novy says.

“It depends on a bunch of factors. One of them is in which currencies you actually make your contracts in. The second thing is that trade in the 21st century has supply chains. So if you are a UK exporter, it is very likely that you also import. Things go in, things go out.”

One such company is Birmingham-based Brandauer. It imports raw materials and exports them as tiny components – nose clips for face masks, earthing rings for kettles and grab rings for plumbing fittings. The business has for years tried to mitigate the impacts of exchange rates by buying and selling equal amounts in the same currency. At the moment it’s not enough to offset the weak pound.

“The increased cost of our imports is probably a little higher than the benefit of our cheaper processing costs. We’re about 70pc raw material, 30pc conversion. So you can see that the positives are more outweighed by the negatives,” says Rowan Crozier, chief executive.

He sees one benefit however: “China is getting more expensive for us to import from which will mean we’ll do more of it in-house. We’ll do it ourselves. I would say that’s a good thing.”