ORLANDO, Florida, June 29 (Reuters) - Britain has an inflation problem, but imagine how much worse it would be were it not for the strong pound?
Not only is sterling's strength keeping current inflation, as bad as it is, from being even higher, it could also play a major part in driving it substantially lower next year.
There is a general assumption that the highest inflation in the G7 Group of rich countries - by some distance - is in part due to sterling's chronic and persistent weakness since the Brexit referendum shock of seven years ago.
But of all the factors pushing up UK inflation, including some that are unique to Britain's economy, labor market and cost of doing business as a consequence of Brexit, a weak exchange rate is not one of them.
Since sterling's initial 10%-15% plunge in the months immediately after the Brexit referendum shock in June 2016, the currency has mostly held its own. It has been particularly buoyant since the pandemic, barring the debacle last September when then-Prime Minister Liz Truss's fiscal plans briefly crashed UK markets.
Indeed, sterling's value on a real effective exchange rate (REER) basis is the highest it has been since the Brexit vote. It is up nearly 7% so far this year which, if sustained, will be its biggest annual rise since 2009.
Perhaps counterintuitively, analysts in large part attribute this to the stickiness of inflation - this will force the Bank of England to raise interest rates more than other countries and keep them high for longer, giving the pound a wide rate and bond yield advantage over its peers.
Consumer prices in Britain are rising at an annual rate of 8.7%, down from a peak of 11.1% in October but still between 2.3 and 5.5 percentage points higher than its G7 peers. Core inflation excluding food and energy, at a three-decade high of 7.1%, is still rising.
Dennis Novy, professor of economics at the University of Warwick, says the relationship between the exchange rate and inflation has not broken down, but has been overshadowed by Brexit-related issues and world food and commodity price shocks.
"UK inflation would indeed be even higher if sterling had not appreciated," Novy said. "The usual FX/inflation transmission is in operation as expected, but it is not as easy to see as (it was) in the wake of the Brexit referendum."
TIGHTEST FINANCIAL CONDITIONS SINCE 2009
Novy co-authored a 2017 paper, "The Brexit Vote, Inflation, and UK Living Standards", since updated, which found sterling's 10% plunge after Brexit pushed inflation up by 2.9 percentage points over the next two years.
This fits with BoE research that a 10% depreciation of sterling translates into a 2.7-percentage-point increase in CPI inflation over three years, with half of that rise likely in the first year.
But can that be applied in reverse? It is hard to compare a one-off depreciation shock with a more gradual appreciation trend, like sterling is experiencing currently, especially with so many other factors feeding into inflation.
In the topsy-turvy post-pandemic world shaken up even further by the war in Ukraine, previous long-standing economic rules of thumb are being called into question. Quantifying the impact of sterling's strength on inflation is difficult.
But the direction of travel may be clearer, especially if the BoE delivers the tight monetary policy over the coming 18 months that markets - and sterling - are now indicating.
Benchmark UK interest rates are projected to be the highest among G10 countries next year at more than 6%, and two-year and five-year UK bond yields are already the highest in the G10.
As Alan Ruskin, chief international strategist at Deutsche Bank, points out, currencies with high inflation are being rewarded as long as the central bank retains sufficient inflation-fighting credibility in the eyes of the market.
This applies to the pound and the BoE right now.
"We didn't get sterling weakness in the past, so we shouldn't expect it now with rates going up," Ruskin said, noting the considerable tightening in broader financial conditions as well.
According to Goldman Sachs, UK financial conditions are the tightest since June 2009. The bank's UK financial conditions index has risen 110 basis points this year, with trade-weighted sterling's rise accounting for around 60% of that, and higher long and short rates accounting for around 40%.
All else being equal, and taking into account the notorious 'long and variable' lag between interest rate hikes and cooling price pressures, UK inflation could come down pretty quickly next year.
(The opinions expressed here are those of the author, a columnist for Reuters)
(Repoprting by Jamie McGeever; editing by Jonathan Oatis)
