England is separated from the continent by the English Channel. It is joined to the United States by a common culture and language but when it comes to economics, ‘La Manche as the French call the English Channel is a tiny stream and the Atlantic remains an ocean. The United Kingdom and the European Monetary Union (EMU) are far more closely tied to each other economically than either is to the United States. Each is the other’s biggest trading partner and what happens in one economy is mirrored across the stream.
In the past generation England has enacted far more reaching economic reforms than the continental powers. Its economy is more flexible, less protected and more open to outside influences. In that it is much closer to its cousin across the Atlantic, but it remains inextricably tied to Europe. The economic freedom that has let the English economy flourish has also left it open to the dangers that have blown through the world financial system since the credit crisis blew up last August. The Northern Rock failure does not yet have its counterpart on the continent. Has the more open economic system of the British Isles left it more vulnerable, is it simply leading the continent in the economic cycle, or is something else affecting the relative movements of the pound and the euro against the dollar?
Sterling peaked against the dollar last November at 2.1158. To the close on Friday it had fallen to 1.9535 or 7.7% from that November peak. This is not quite the low, in late January it dropped to 1.9335, then returned to 2.0300 in mid March before falling again.
In contrast the euro peaked only two weeks ago (4/22) at 1.6017 and at close on Friday (1.5475) was just 3.4% beneath the high.
Yet the economic statistics for both the European Monetary Union and Great Britain over the past year show a strikingly similar pattern.
Nationwide consumer confidence peaked in the UK in September last year at 99; it was at 70 in April. EMU consumer confidence topped out at -1 in May of 2007; it has been at -12 since January of this year.
The manufacturing Purchasing Managers Index (PMI) scored 56.1 in Great Britain last August; it had dropped to 51.3 by March of this year. In the EMU manufacturing PMI reached it cycle high 55.8 in June of 2007; it has since fallen to 50.7.
Services PMI exhibit a similar pattern. In Britain it peaked at 57.6 in August 2007; by April 2008 it was at 50.4. On the continent PMI for the service industry topped out at 58.3 in July 2007; by April of this year it was at 52.0.
GDP has shown nearly identical declines. In the UK it was 3.3 % (annualized) in the third quarter of 2007, 2.8% in the fourth and 2.5% in the first quarter of this year; a 24% slide in three quarters. In the EMU GDP was 2.7% in the third quarter of last year, 2.2% in the fourth and it likely to be 2.0% or lower in the first quarter of 2008; a potential 25% fall over three quarters. The actual result for the EMU will not be released until June 3rd.
Because we are measuring both currencies against the usd, the effect of developments in the America is not a factor. In the EMU and in Britain the economies peaked in late summer last year. In Britain that economic apogee was followed just a few months later by the high of its currency against the dollar. But that is not so for the euro which continued to climb against the dollar for eight more months.
Two factors have altered the performance of the sterling against the usd. First but not foremost, has been the perceived effect of the credit crisis and housing problems on the UK economy. British housing prices have been falling faster than on the continent and there is greater use of mortgages for home ownership in England. British financial institutions and the economy are more subject to the vagaries of the domestic housing market. In response to this weakness the Bank of England has begun cutting rates.
As we can see from the comparative statistics, the UK and EMU economics are largely in sync. The one thing standing in the way of a comparable fall in the euro against the dollar has been the ECB. The susceptibility of the euro to rate cut speculation was especially evident in February. Over the 5th 6th and the 7th the euro dropped 400 points in anticipation of a change in the central bank’s rate stance. At the ECB meeting of the 7th the bank did move to a neutral bias. But in the days that followed the ECB made a concerted effort to neutralize the effect of its changed bias. Bank spokesman emphasized its inflation mandate in sound bite after sound bite, even and deliberately alluding to the possibility (which few credit) of a rate hike if inflation was not controlled. The ECB expended its rhetorical energy in squelching the dollar rally against the euro because it would have undermined its anti-inflation campaign.
At 3.6% in March and 3.3% (annualized) in April inflation is high in Europe, almost double the ECB target rate of 2.0%. But the economic situation in the EMU and the credit worries worldwide have prevented the ECB from hiking rates. The board of governors is left with only one weapon in their inflation fight: rhetoric. But rhetoric is subject to serious diminishing returns. The more it is used the less effective it will be. The strongly anti-inflation comments in the ECB statement and at Mr. Trichet’s press conference on Thursday had little effect on the euro. Constant use has blunted the ECB rhetorical weapon. Sooner or later, and it now appears sooner, the euro will fall in line with the EMU economic performance. The next ECB rate move is still likely to be a rate cut.
If the euro were to fall a similar amount from its peak as the sterling has, 7.7%, it would be at 1.4775 or so. That is the goal whether or not the ECB continues its rhetorical support of the euro.