Not many years ago it would have seemed an astonishing achievement for the British economy to have demonstrated seven years of steady growth and low inflation. That remains the most likely outlook for the next two years too, according to yesterday's Inflation Report from the Bank of England.
Sadly, the economic barometer is anything but settled. The strong pound - or weak euro - means that manufacturing is in the doldrums while services continue to boom, creating an increasingly pressing dilemma for the Monetary Policy Committee.
Mervyn King, deputy governor of the Bank of England, made it clear that exchange-rate concerns had swung the committee's latest few votes in favour of leaving interest rates at the current level of 6 per cent.
"Despite signs of greater cost pressures, interest rates were left unchanged throughout the quarter. A major contributory factor was the exchange rate," he said, presenting the quarterly Inflation Report.
Indeed, the sterling index against other currencies averaged 110.7 in the two weeks to 3 May, when the forecast was finalised, compared with its 109.4 level in the run-up to February's Inflation Report. The index has recently remained near its highest levels since 1985. Most of the appreciation has been against the euro, and reflects huge shifts in the dollar-euro exchange rate. In recent weeks the pound has declined against the US dollar.
Mr King went on to issue a turbulence warning yesterday. The imbalances in the economy meant the current level of the pound was unlikely to be sustainable, he said, and there could be a sharp fall in its exchange rate against the euro.
The main symptom of unsustainability is the widening trade deficit, reflecting the difficulty of selling expensive British goods overseas at the same time that the buoyant home economy is sucking in cheaper imports. Last year the current account deficit ballooned to £12.8bn from near-balance in 1998, and most forecasts have pencilled in a shortfall of about £17bn for this year.
The Inflation Report noted: "The outlook is for further deterioration of the UK trade balance if the exchange rate remains high." In addition, as growth in the eurozone region picks up, the prospect of further European Central Bank rate rises should also help to turn the exchange rate around, sending the euro higher and pound lower.
If there is a sudden correction in the pound, it will put upward pressure on inflation and might trigger further increases in interest rates. For, if the pound had not stayed so high recently, over-rapid growth in domestic demand would have prompted the MPC to raise the cost of borrowing.
However, the danger of a sharp drop in sterling is not reflected in the Bank's usual "fan chart" for the inflation forecast, which assumes only a gentle decline in the exchange rate. The forecast therefore still shows a high probability that the target measure will lie in the 1.5 to 3.5 per cent range.
Mr King said: "This one specific risk has been omitted." The scale and timing of a potential exchange-rate correction were simply too uncertain to incorporate into the forecast, he explained.
Geoffrey Dicks, UK economist at Greenwich NatWest, pointed out that this was quite a big omission. Virtually every other indicator - like world activity, domestic demand and earnings - had been stronger than when the February inflation forecast was published, and the Bank is forecasting that GDP growth will remain above 2.5 per cent.
"The conclusion is that the MPC is boxing clever tactically," Mr Dicks said. Some support for this came from yesterday's fall in the pound - better a gradual decline than a sudden reversal.
For many British businesses, of course, a sharply weaker pound could not come a moment too soon. Business organisations have been urging the Bank to help it along by signalling that interest rates have peaked - a tactic firmly rejected by Mr King yesterday as something that would tie the MPC's hands unnecessarily. Some economists fear, however, that if the pound does fall, the committee will offset the gains to business by responding with automatic interest-rate rises.
Ian Peters, deputy director general of the British Chambers of Commerce, said: "What we want to see is a sustainable reduction in the strength of sterling. If we do see the pound begin to weaken, and the euro begin to strengthen, the Bank needs to be very cautious about responding with increases in interest rates."
He added: "Businesses could live with marginally higher rates if they were matched by a lasting reduction in the exchange rate."
The fears of an almost mechanical rise in borrowing costs are probably overdone. David Walton, an economist at Goldman Sachs, said: "Inevitably, the MPC does take all monetary conditions, including the exchange rate, into account when they set interest rates. But unless the pound comes down quite a lot, interest rates will probably not have to go up at all."
The reason, he said, was that conditions were already tight enough to generate the slowdown in domestic demand growth the Bank is looking for. He predicted that there is little danger of interest rates rising above 6.5 per cent, even with a weaker pound.
The Inflation Report also noted that the prices of imported goods had not fallen as much as expected so far, suggesting that importers had not passed on the full benefits of the strong pound, padding their profit margins instead. If that is the case, they will be able to absorb some of the inflationary pressures caused by a weaker pound in lower profit margins.
It is also clear that there are still wide differences of opinion on the MPC about prospects for the pound and inflation, and split votes are unlikely to lead to rapid shifts in monetary policy.
Still, as Mervyn King warned yesterday, the past three years have seen inflation staying remarkably close to its target, with growth cruising along. The economy's steady performance might prove too tricky to sustain.Reuse content