A strong pound gives lucky Ken a window of opportunity

There is less need for a rise in base rates before the election, for you can argue that the exchange rate is tightening policy enough
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The Independent Online
In case you haven't noticed, sterling has suddenly become the hot currency on the exchanges. Yesterday it was over $1.61 against the US dollar. More important for business, though not for holidays, it was up to DM2.45 against the mark.

One can dismiss this as a typical example of the sort of swings that take place on the currency markets, the result of a change in interest rate expectations or simply a change in fashion. Wait a while and it will all be reversed - just as the excessive weakness of the pound through last winter is now being overturned.

There is a lot to be said for this laid-back approach, for anyone who follows currency markets will know that they invariably overshoot. But while there be no great wider meaning in the recent rise of sterling, it does have practical consequences for the conduct of economic policy. Kenneth Clarke seems to be a lucky Chancellor.

He has been lucky over the last year when his decisions to cut interest rates, sometimes against the advice of the Bank of England, have been validated by slower-than-expected growth in the economy and lower-than- expected inflation. But many commentators now reckon that the run of luck has run out: the latest figures show a surge of growth in the early autumn which, it is assumed, will lead to an early rise in interest rates, perhaps before the end of the year. Maybe, though, the luck has not run out after all. If the pound rises enough, the politically disagreeable need to increase rates is postponed.

A rise in the exchange rate has three main effects. First, it is equivalent to a partial tightening of monetary policy in that it tends to squeeze the exporting sectors of industry - the Treasury has a four-to-one rule of thumb, with a 4 per cent rise in the exchange rate equivalent to 1 per cent on base rates. We have had a rise of about 6 per cent in the trade-weighted index this year (left hand graph), so you could argue that any loosening of interest rates over the last year has been fully offset by the rise in sterling.

The second impact is that in the short-term at least the rise will improve the current account. Obviously in the longer run a higher currency prices exports out of markets and makes imports cheaper and so undermines the current account. But in the short term the reverse is true, and this "short term" can last a year or more. The current account is not a problem at the moment - it was in surplus during the last three months - but the rise in the pound will help ensure that it will not be a problem through the winter.

The third impact is on inflation: a higher pound will cut the price of imports and thus reduce inflationary pressures. This comes at a convenient time, just as oil prices in particular have been rising sharply and other commodity prices may follow.

The rise against the dollar, the currency in which most commodities are priced, is particularly helpful (right hand graph, below), for that has a direct impact on the price we pay for raw materials. To some extent we are able to insulate domestic prices from this global commodity price pressure. Meanwhile as a net exporter of oil, we benefit from the higher oil price - that is one of the things which is helping push the pound up.

The effect of all this is two-fold. First and most obviously, there is less need for a rise in base rates before the election, for you can at least make a decent argument that the exchange rate is tightening policy enough. True, the tightening bears on manufacturing industry rather than the economy as a whole, but in the short term that should be more popular: companies do not vote; home-buyers do. Of course there may be a rise in rates, even conceivably this week; but the odds have come down.

Second, and less obviously, the rise in the exchange rate may be associated with an increase in the room for tax cuts in the Budget. It does not increase the room for cuts directly but there are loose associations. Thus if a stronger sterling is partly driven by higher oil prices, that of itself will lift North Sea tax revenues. If a stronger sterling helps bring down long-term bond yields that cuts the cost of debt service. The numbers are not big, but anything which can add a billion to revenues or cut a billion off debt service is helpful when looking for tax cuts.

Beyond this, there may even be a "halo" effect on the Government. Much of the perception of economic failure that has dogged the Government, despite the decent economic recovery, has been associated with the ejection of sterling from the ERM. There was a perception of failure which was politically damaging, despite the practical benefits which the weaker pound has brought to the economy. If the pound now appears rather stronger, that fact alone should offset some of the political damage. Strong currencies are linked in the public mind to strong economies, even if over-strong currencies damage economic growth.

So the Chancellor has a window. We have been reaping the benefits of an overly competitive exchange rate; now a partial reversal of that situation brings some further short-term benefits in the form of lower inflation, an invisible tightening of monetary policy, and a more general perception of economic success.

Too good to be true? Well, yes, because the recovery of sterling cannot and should not proceed too far; to do so would undermine the whole economic recovery. But for the next six months, it is very helpful to the Government, even if rather unfairly so.

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