Continental drift

ON DECEMBER 3rd the European Central Bank (ECB), which looks after the euro zone, pushed one of its interest rates deeper into negative territory. On December 16th America’s Federal Reserve is expected to go the other way, raising interest rates for the first time since 2006 (see article). The diverging policies in Britain’s two main markets mean that the pound now finds itself being tugged in opposite directions.

As worries about the world economy deepen, investors have been queuing up to buy British assets. The country is seen as an island of stability and may end up the fastest-growing economy in the G7 in 2015. The result has been a rapid appreciation of the pound, though it remains below its pre-crisis peak (see chart). At first glance, events seem to conspire against further appreciation. The ECB’s move has helped to form a consensus among investors that Britain’s rates will not rise until 2017. They are betting that what happens in Frankfurt will sway the Bank of England’s economists on Threadneedle Street.

But monetary policy in 2016 will probably be tighter than markets expect, argues Ruth Miller of Capital Economics, a consultancy. The prospect of the Fed raising rates has not yet spooked American investors. If all goes smoothly following the Fed’s decision, the Bank of England will feel happier about increasing rates, especially as inflation will soon go up as lower energy prices drop out of the year-on-year comparison.

In its latest inflation report, published in November, the bank subtly implied that investors had been too quick to write off the possibility of interest-rate rises. A mini-budget delivered by the government on November 25th only strengthened that view, because it showed that austerity would be slightly less of a drag on economic growth than had been feared.

If sterling does appreciate in the coming months, some will rejoice. The recession ended six years ago, but households’ inflation-adjusted disposable incomes per head are no higher than before the crash. Imports would become cheaper, buoying up living standards.

But an expensive pound also stokes up problems. British firms, which as a share of overall economic activity export less today than three years ago, would be even less competitive in foreign markets. Hopes of export-led growth would dim further.

Britain’s external position is vulnerable in another way. The current account, a measure of the difference between what Britain borrows and lends abroad, is likely to have run a deficit of about 5% of GDP in the third quarter, by far the highest of any big, advanced economy. Higher imports and lower exports will pump it up further.

To finance a rising current-account deficit, Britain needs foreigners to buy its assets or lend to its residents. But finding customers is getting trickier. As the pound has strengthened, the price of a house in Kensington and Chelsea, a London borough prized by Russian oligarchs, has in two years risen by around 50% in euro terms (and getting on for 150% in rouble terms). A report by Deutsche Bank sees 2015 as a “turning point” for the top end of London’s property market. A dear pound also makes Britain less attractive to foreigners looking to set up new offices or acquire firms.

As long as Britain keeps in investors’ good books, its current-account deficit is manageable. But that could change. Within the next two years Britain will hold a referendum on its continued membership of the European Union. If it quit, investors would no longer see it as such a safe haven. That would bring down the pound. In 2016 monetary policy may not be the biggest driver of sterling.