What’s happened to the pound?
The pound has gone up and down a lot over the past two years, and has been particularly volatile since the outcome of the EU referendum. The latest development came after October's manufacturing PMI suggested the UK economy is starting the fourth quarter on a strong footing, therefore raising odds of a rate rise at tomorrow's MPC meeting.
How do manufacturers feel about exchange rate movements?
But it is not just us – economic nerds – who worry about exchange rate movements. Manufacturers are at least as concerned as we are.
Last year, 85% of companies answering our Executive survey identified sterling movements as a risk to their business plan in 2017 – an all-time high in the survey’s five year history. Four in five manufacturers linked this risk to Brexit, reflecting not just the plunge in sterling value but also the heightened volatility in the wake of the EU referendum − the latter moderating slightly from previous peaks around the Brexit vote.
So how did the sector react to last year’s depreciation in sterling?
Last year, we made some predictions about the impact of the sterling depreciation on UK manufacturers.
Most importantly, we thought that the impact of the sterling depreciation is much more complex than most people think, that it would take some time to materialise, and that it would be passing through various mechanisms.
So what has actually happened?
1) Margin pressures started to ease as UK prices went up
While sterling depreciation instantly pushed up import prices – and hence input costs, manufacturers did not immediately increase output prices on UK sales. This meant that UK margins were squeezed for a few quarters following the depreciation.
EEF's Manufacturing Outlook survey shows that price balances for UK sales climbed back into positive territory in 2016q4 and reached a five-year high in 2017q1, while the pressure on UK margins persisted until 2017q2.
This is consistent with the trend in consumer price inflation. CPI started to rise gradually in 2017 and at a quicker pace than in other advanced economies. The pass-through of the sterling depreciation was still on-going in September where CPI soared to 3%. In the meantime, margin pressures started to ease.
2) Consumers' pockets were squeezed
The rise in consumer price inflation, coupled with sluggish wage performance over the past year, squeezed consumer pockets. As a result, household consumption decelerated significantly, growing by +0.3% in the first half of 2017 compared with an average growth rate of +0.6% since the recovery from the great recession was on track.
The rise in CPI did not seem to have created upward pressures on pay – thus containing second-round margin pressures. The reason is that inflation has not been the only factor driving pay growth in the past year, and we do not see reasons for wages to start growing any time soon…
3) Export prices did not fall
We particularly got it right on this one. Export prices did not necessarily adjust downwards following the sterling depreciation. As UK manufacturers are strongly integrated into global value chains, the surge in input costs explains this trend as the sterling fall is also passed through to overseas clients in order to preserve margins on export sales.
This is consistent with previous research by the ONS, which found that following earlier episodes of depreciation export prices moved alongside import prices.
The response was different across industries, partly reflecting the different import intensity of exports. These results provide another evidence of how exchange rate movements affect firms’ pricing strategies abroad.
4) Export sales went up, but this is not all down to sterling
UK manufacturers have experienced a boom in export sales this year – but this is not all down to sterling. Global markets turned a corner this year, ending a decade of lacklustre growth in world trade. Growth was particularly sustained in Europe, which accounts for around half of UK exports.
To sum up…
Sterling movements have affected manufacturers in many ways, and their effects continue to feed through several months following the depreciation.
This impact depends on firms’ exposure to exchange rate variations – namely its reliance on imported inputs as well as the share of exports as a proportion of total output. These differ significantly across sectors, and so does firms’ perception of exchange rate risk.
 Hardie, Jowett, Marshall, Wales (2013): “Explanation beyond exchange rates: trends in UK trade since 2007”, Office for National Statistics, August 2013
 See for example Paul Krugman (1986): “Pricing to Market when the Exchange Rate Changes”, NBER Working Paper No. 1926, May 1986