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COMMENT : Falling sterling brings a new dilemma

The economic landscape has changed quite dramatically during the past few weeks. Conversation at the 2 February meeting between the Chancellor and the Governor of the Bank of England, which took place before Barings and before the titillating departure of the Bank's deputy governor, revolved around the strength of economic growth and cost pressures that appeared to be spreading down the production pipeline. The minutes, published yesterday, revealed that the only question about base rates was when to raise them, not whether.

The evidence for their next meeting, on 5 April, will be that growth has indeed slowed. Retail sales, industrial production, surveys and trade figures all point to the conclusion that it is decelerating. But that in itself will not be enough to eliminate fears that further interest rate rises will be needed.

One reason is that the pound's value against a basket of other currencies has dived by 4.5 per cent since the new year. Most of the fall has occurred since the 2 February decision to raise base rates. Sterling's slide adds to the inflationary pressures in the economy.

On most economists' rule of thumb, a 4 per cent fall in sterling has the same inflationary impact as a 1 percentage point cut in interest rates. Obvious conclusion: the actual half-point increase agreed in February has been more than neutralised by sterling's fall.

So Ken and Eddie will face a new dilemma at their next meeting if the pound has not recovered by then. Do they focus on the domestic evidence of a weaker economy or the external pressures on prices? After all, the price of imported goods has already gone up 6.5 per cent in the first two months of this year.

Part of the Governor's argument on 2 February was that moving earlier than many in the City had expected in September and December had actually reduced expectations of future interest rates and inflation. For example, between November and the beginning of February, the expected base rate at the end of 1995 implied by the short sterling futures market dropped from 9 to 8.5 per cent.

Since the latest base rate rise it has fallen again, to 8.1 per cent. The Governor was right. An early move did improve market perceptions. It would work again now. There seems little doubt that there will be another rise in British interest rates some time between now and the summer. The arguments might be finely balanced in April, but would be less so by May or June.

It is fine-tuning of the most old-fashioned kind to think that postponing the decision by a few weeks would actually make much difference to the inflation rate by the end of this Parliament. But it might make all the difference to market expectations if sterling is still wobbly. Tony Blair's talk of putting the Labour party on a war footing for an imminent general election - whether bluff or not - can hardly do much for the pound's short-term prospects, since the chances of a change of government are so high.

Of course, when inflationary prospects seem to be deteriorating, one answer is always to change the definition of what inflation is. Today sees the first publication by the Central Statistical Office of a new monthly measure known as RPIY. This is an index that excludes indirect taxes as well as mortgage payments, and is, in the Bank's view, a better measure of underlying inflation in the economy than the better-known measures, RPI and RPIX.

Happily for the Bank, the new measure is certain to show that inflation is lower than on the other two measures. It could therefore be used to ease the transition from the present 1-4 per cent inflation target to a new lower range. But nobody, least of all Mr George, is likely to put much faith in this new series in isolation.

Several new sets of economic statistics are out before Mr Clarke and Mr George next meet. They include the influential quarterly trends survey from the Confederation of British Industry. Stronger signs of growth or inflation would bring the horns of the policy dilemma closer together. Mr George and Mr Clarke might as well opt for higher base rates next month as the month after, and get it over with quickly.

Orphans can work wonders for insurers

Bonanzas have been rare in the life insurance industry in the past few years. But for shareholders in a few select companies, that may now be changing. They are the ones with shares in the likes of Britannic Assurance, which yesterday announced it is to follow the example of United Friendly and distribute surplus profits from its life fund to shareholders.

A handful of other companies, including Refuge, are poised to follow in Britannic's wake and release some or all of the value in their so-called "orphan" funds to shareholders. Legal & General is studying the matter too. The rationale for all these moves is that shareholders are entitled to the benefit of any surplus that remains once all commitments to policyholders have been met and prudent calculations about future liabilities taken into account.

In the one case where the issue has so far been brought to a conclusion, United Friendly took the sting out of any potential anger from policyholders by agreeing that they too should receive a special one-off bonus of £86m from the proceeds. In Britannic's case, the exact amount that can be allocated to shareholders depends on a series of complex actuarial calculations. It will probably take a year to reach a final decision.

What is behind this sudden wave of interest that has sent the actuaries to examine dusty life company records, some of them from the Victorian era? The answer is the obvious one: insurance companies are feeling the pinch, and those that cannot demonstrate they have a profitable future know they will soon be in trouble. Increased competition, deregulation and growing consumer awareness are putting the industry's management - in some companies, still almost as cobwebbed as their more vintage policies - in the spotlight.

It seems inevitable that the insurance industry will contract dramatically over the next few years. Mergers and takeovers are widely expected. "Vulture funds" are actively plotting to take over sleepy life funds and place them under new, more aggressive, more shareholder-oriented management.

Distributing orphan funds is an obvious way to try to earn some shareholder loyalty. The sharp rise in the share price of companies with orphan funds since the United Friendly announcement suggests that it works, at least in the short term. United Friendly, Britannic and Refuge are the main beneficiaries.

Not surprisingly, since any attempt to realise the value of orphan funds places the interests of policyholders and shareholders in conflict, there is scope for objections to what is now being proposed. Sir John Nott, the former chairman of Lazards, is attempting to rally support for policyholders at Legal & General. He rightly wants to see the criteria for taking such decisions made more explicit - not least because they come at a time when policyholders are being told that bonus rates are being cut because of falling investment returns.

The ultimate arbiter of these matters is the Department of Trade and Industry. Any release of surplus funds has to be agreed with the regulators at the DTI. That inevitably takes time: something like two years in the case of United Friendly. Last month the DTI issued a new set of guidelines on the subject. That is a start, but the issue needs a thorough airing.