26 February 2013

The Pound in Free-Fall

There has been a bit of excitement in the last few days over the fall in the value of sterling. Here is The Sunday Times going over the top in a "news" story:
Experts warn there could be a major slide in sterling with the pound heading to parity with the euro for the first time since the financial crash of 2008-09.
Plenty of others have commented on the benefits of a lower pound, but my thoughts turned elsewhere. What is a reasonable value for the pound against the euro? Britain has experienced higher inflation than the eurozone in recent years and so you would expect the value of sterling to fall relative to the euro.

The OECD produces some figures on purchasing power parity (PPP), which compares the values of currencies in terms of what they can buy. This gives a quick was to estimate the fair value of the exchange rate (at least for the recent past). I have worked the figures to put them on a chart.

Source: OECD, author's calculation
So back in 2005 the PPP rate was 1.32 € per £. This fell rapidly to 1.15 in 2009 and has been at 1.13 € per £ since 2011.

A quick check of the FT shows the market rate is now 1.1655 € per £. So the current market value is probably sightly above the fair value, especially as inflation has continued to be higher in the UK than in the eurozone. The recent slide has in fact brought the market rate closer to reality.

Update: I could do the same for the pound against the dollar. The OECD figures suggests an PPP exchange rate around 1.47 $ per £ in 2011 and 2012. At the bottom of the recent slide the market rate remained above 1.50 $ per £.

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