Unlike commodity prices – and world prices more generally – over which the United Kingdom has no direct control, an exchange rate represents the relative price of two currencies and is thus affected by monetary policy decisions at home and abroad. The timing of the depreciation, however, and its subsequent relative stability makes it natural to attribute the fall not to changed expectations of monetary policy at home and abroad, but rather to the perceived real impact of the crisis on the UK economy. Prior to the crisis, the United Kingdom was consistently running a moderate current account deficit. At some stage, that deficit needed to be closed, most probably through a higher national savings rate. The natural counterpart to that would be a real depreciation of sterling in order to improve UK international competitiveness, boosting net exports and leading to a re-balancing of the composition of output away from meeting domestic needs and towards internationally tradable sectors. Moreover, the crisis has probably also resulted in a loss in net foreign earnings by some parts of the financial sector, necessitating an even larger decline in the real value of sterling to re-balance the economy. In order to get a handle on the likely impact of the depreciation of the exchange rate, we can follow a couple of approaches. One approach is to compare inflation rates here with those in other jurisdictions with stable exchange rates.
We can bring all this together by asking what has been the net contribution to inflation of higher global prices, the exchange rate depreciation and the movements in VAT over the past few years. A range of estimates is shown by the blue swathe in Chart 9. The green swathe then just shows the corresponding inflation generated from other sources, such as pay and producers’ profit margins. It can be seen that this has been running at very low levels, especially over the past year and a half. It is worth emphasising that this is, in essence, merely an accounting exercise, attributing inflation to various proximate causes. The green swathe does not provide an estimate of what inflation would have been if commodity prices, the exchange rate and VAT had all remained at their 2007 levels. If that had been so, consumers would have had more to spend on domestically produced output, pushing up prices. And producers utilising imported inputs would also have had less incentive to bear down on other costs, including wages. So, in the absence of the movements in global prices, sterling and indirect taxes, inflation might have been somewhat higher than indicated by the green swathe. But these effects would have to be quite powerful for inflation to be materially above target in those circumstances.