Dissecting Sterling’s Fall

Abstract:

The referendum result has prompted a sharp depreciation of sterling, which has declined by over 12 per cent against the US dollar since 23 June 2016. Framed in a risk-adjusted uncovered interest rate parity (UIP) condition, two factors lie behind this adjustment: a rise in the sterling risk premium that relates to the uncertain prospects for the UK economy, and financial markets prices reflecting an expected fall in the level and path of Bank Rate. We use this rise in the risk premium to simulate the implications for output and inflation in our global econometric model, NiGEM. We find that in response to the increase in the sterling risk premium alone, inflation increases by 0.6 percentage point on average in 2016, while the peak effect on output is a rise of 1.2 per cent in 2017, relative to baseline. A way to gauge the quantitative importance is to calibrate the decline in Bank Rate required to match the output response triggered by the sterling risk premium shock. We find that the decline in Bank Rate would have to be around 200 basis points to induce a similar output response in 2017.

NiGEM Observations is a series of occasional notes published by the NiGEM team on topical macroeconomic modelling issues for NIESR corporate sponsors and NiGEM subscribers.