TESTING EFFICIENCY OF EXCHANGE

Testing Efficiency Of Exchange And Forward Rates Of Dollar To Sterling

Testing efficiency of exchange and forward rates of dollar to sterling

Introduction

The Monetary Policy Committee (MPC) left Bank Rate unchanged once again at its recent meeting. As a result, the policy rate has now been maintained at an historic low of 0.5% for 12 months. The MPC also voted not to extend the £200 billion limit on the stock of assets financed by the issuance of central bank reserves via the Bank's Asset Purchase Facility (APF), leaving quantitative easing (QE) on hold for a second successive month. Both decisions were widely expected.

Discussion

The emerging data continue to paint a mixed picture of the strength of recovery in the UK. GDP is now estimated to have increased by 0.3% during the final quarter of 2009, rather than 0.1%, as the preliminary data suggested. The upward revision brings the official data more into line with estimates of activity based on Purchasing Managers' Indices (PMIs), which suggest that growth has carried over into 2010. Having dipped in January, when activity was adversely affected by heavy snowfall, the service sector PMI surged to a three-year high in February, while the manufacturing PMI remained at January's 15-year peak. Signs of stability in the labour market provided further grounds for cautious optimism, while the Bank will also have been encouraged by the return to growth of the 'non-financial sector' M4 money supply, one of the yardsticks by which it measures the effectiveness of its quantitative easing policy.

However, the underlying fragility of the nascent recovery was also evident in much of the recent data. While consumer demand made a positive contribution to GDP growth in the final quarter of 2009, slower de-stocking provided the main thrust. Net trade and investment had a negative influence on growth, but with stock-building likely to provide only short-term support, other demand drivers will have to pick up if recovery is to become self- sustaining, especially as government consumption (which also contributed positively to GDP growth in the fourth quarter) is set to slow as fiscal policy is tightened.

In addition, although affected by adverse weather conditions and the reversion to the lower stamp duty threshold on 1st January, recent data pointed to renewed weakness in the housing market. Retail sales also weakened in January, although the severe weather and the re-instatement of the full rate of VAT will have influenced the data, with the latest CBI survey suggesting an improvement in February. Weak fourth quarter growth in the eurozone, the UK's main trading partner, also raised concerns over the durability of recovery in mainland Europe and, as a result, the outlook for UK export demand.

Consumer price inflation jumped to 3.5% in January, prompting the Governor of the Bank of England to send a letter of explanation to the Chancellor. This stated that the recent rise in inflation was due to temporary factors, including the restoration of the full rate of VAT, higher oil prices and past sterling ...