Will a falling pound cause sky-high inflation?

The main financial news story of recent days has been the falling pound. It's now at an all-time low versus the dollar at £1/$1.22. Looking ahead, it could go even lower due to declining confidence in the UK economy, a US interest rate rise that may cause the dollar to appreciate and an ultra-loose monetary policy pursued by the Bank of England. Will this cause inflation to soar?

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A weak currency causes imports to become more expensive. This has started to become evident this week as the standoff between Tesco and Unilever has dominated news headlines. Unilever is attempting to raise prices by a rumoured 10% because it says that its costs are now higher. In response, Tesco isn't restocking Unilever goods since it apparently doesn't wish to pass on the price rise to customers for fear of becoming uncompetitive versus rivals. Nor does it wish to bear the higher cost itself, which would be to the detriment of its own financial performance.

To pass on costs or not to pass on costs?

The situation between Tesco and Unilever is one likely to be repeated in a range of industries. That's because imports are inevitably now more expensive than prior to the EU referendum. The impact on inflation is down to whether the companies that experience higher costs choose to pass them on to consumers in the form of higher prices or whether they choose to keep prices as they are and absorb the costs themselves.

For most goods that have a positive price elasticity of demand, the burden of higher import costs could be shared between buyer and seller. This would hurt the financial performance of UK companies that rely on imports and it could also cause inflation to spike in the short term.

However, inflation may not reach sky-high levels. Certainly, an increase from the current level of 0.6% seems very likely, but other factors may keep it at historically normal levels. Among these are UK interest rates, which may have to rise in order to combat inflation. The scope for this to take place may be higher than many investors realise, since a weak sterling provides a boost to exporters. This could have a positive impact on UK economic growth and mean that an interest rate as low as 0.25% is no longer desired.

Furthermore, the world economy is still facing a period of deflation. This has lasted since the credit crunch and it's a key reason why the Federal Reserve and Bank of England have maintained a dovish stance on monetary policy. A slowdown in China is expected to continue over the coming years and so the impact on inflation of a weaker pound may be offset by global deflationary forces. And with inflation in the UK being near-zero in recent months, it has a long way to go before it reaches a worryingly high level.

So, while the weak pound is likely to stay over the coming months, the level of inflation may not reach troublesome levels. Therefore, the fear it's creating among investors could be a good opportunity to buy high quality UK-focused stocks at a discount to their intrinsic value.

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Peter Stephens owns shares of Tesco and Unilever. The Motley Fool UK owns shares of and has recommended Unilever. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.