Comment: Bluster from the Bank is unhelpful

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The Independent Online
The currency market pressures continue, with at least four sources of tension operating on the exchanges: the plight of sterling; the tensions within the exchange rate mechanism; the underlying upward trend of the dollar; and the growing feeling that the yen needs a sharp upward move if the Japanese current account surplus is to be brought under control.

Sterling first. The conventional wisdom, well articulated by NatWest Capital Markets' new Global Currency Outlook, is that the pound will test further lows in the coming weeks; NatWest warns of the pound falling below dollars 1.30 and DM2.30. The reason: 'The lack of coherence of economic policy is not expected to end in the short term and this will hold back international investors' willingness to move into sterling.' Most market operators would find it hard to quarrel with that.

The person who does quarrel with this negative view is Eddie George, Governor-designate of the Bank of England. In his first speech since his appointment, made yesterday in Frankfurt, he managed to attack both the host country and the financial market commentators. His second sentence started: 'After two devastating experiences of hyper-inflation during this century the German people have long understood the crucial importance of monetary stability . . .' This is rather like a new British foreign secretary reminding the Germans that the foreign policies of Kaiser Wilhelm II and Hitler were sub-optimal - true, but as the Treasury says when someone writes something disagreeable about its economic policies, unhelpful.

He also had a go at the commentators. 'I have no sympathy at all for those supposed pundits who continuously complain that policy is obscure or even non- existent and that we are living hand-to- mouth. And I have no sympathy for those commentators who scrutinise the fine print of every official statement trying to detect the most minute differences of emphasis as between growth and stability from one day to the next.'

Further cuts

This bluster, following the hash that the authorities made of the last drop in rates by saying one thing one day and doing the opposite the next, is also unhelpful. He made some comments about future interest-rate policy, suggesting that there will be no further cuts for a while. That is interesting, and it is good that he should speak out in this way. But, as he admits, the Bank will be judged by what it does, not what its new Governor says.

What it does will be watched extremely closely in the coming weeks. The indicators of monetary conditions point in different directions: narrow money is running above the target range, but broad money is below; house prices are clearly signalling that monetary conditions are not too easy, but the exchange rate is signalling that they are. So out of the four main monetary indicators two are pointing up, two down.

The moral probably is that there should be no change in interest rates until at least three are pointing in the same direction, and it remains wholly possible that the next change in rates, when it comes, will be up rather than down. If interest rates do come down without monetary justification, then the markets' current scepticism about sterling will be justified. Meanwhile, the conventional view that the pound has further to fall before it can recover is probably right.

But it will recover. It has achieved little notice, but sterling is now below its purchasing power parity. New calculations by Citibank suggest that the PPP rate for the pound is about dollars 1.50 and DM2.65. At present it is a good 10-15 per cent undervalued. All past experience of PPP as an indicator of exchange rates suggests that (a) the lags are long and it may be some time before exchange rates adjust, but (b) eventually they will. On a three-year view, sterling should now be a 'buy'.

The ERM game continues. The professional commentators are pretty evenly divided as to whether there will be change in the franc/mark parity this year, but most are sceptical of the proposed timetable to monetary union. The idea that Germany and France should race towards a currency union ahead of the Maastricht timing is surely for the birds. So too, surely, is the idea that the franc and the mark will move to narrower bands, with the Bank of France having greater say in the Bundesbank's policies as a quid pro quo.

Flexible ERM

The practical view is that the Maastricht plan for EMU will be rolled forward. There might still be a 10 per cent chance that the Maastricht timetable will be kept, but currency union is much more likely to take place some time in the first decade of the next century, or even the second decade, assuming it happens at all. Meanwhile, the ERM will become both more flexible and, as a result, politically more acceptable.

The dollar's further climb is also now accepted by the markets as an odds-on bet, certainly against the mark. The point to be aware of is that at present, according to the Citibank figures, PPP for the dollar is DM1.73. A rise above that level is perfectly possible but the further it goes the further the elastic becomes stretched, and so any rise is unlikely to be sustained in the long term.

Finally the yen: PPP is about Y150 to the dollar, so it is already some 18 per cent overvalued. Is it really credible that the yen will appreciate further? This issue is likely to crop up at the forthcoming Group of Seven finance ministers' meeting at the end of this month. The Japanese authorities would be deeply concerned about any significant rise from present levels, because of its impact on export demand and the financial system.

A rise of the yen would tend to depress stock market values. Falling security prices undermine the balance sheets of the banking sector; a rising yen cuts the value of their overseas assets. Together these would be bad news. Whether the authorities are forced to concede some rise in the yen, however, is another matter, for there is likely to be pressure from the US administration to do so.

This prospect of a G7 meeting is interesting. Maybe the G7 will get back into the currency-stabilisation game. Do not expect much from this particular gathering, for the new administration has yet to formulate its policies. But if the dollar is likely to strengthen overall, expect the administration to be seriously concerned about its relationship with the yen.

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