Comment: Worrying signals for the markets

It would have been very odd, given the pressure on the Government, the impact of lower base rates and the continuing weakness of the economy, for the pound to have put on much of a show on the exchanges yesterday. But the new fall to below 80 on the sterling index is slightly alarming.

In the past few days, the financial markets have been faced with two new pieces of information, one on British policy, the other on the world economic outlook. Neither is encouraging.

The new information on British policy is that, for the time being, British interest rate policy is wholly driven by politics. There are perfectly respectable arguments for wanting to squeeze down British interest rates, but the way in which the last fall was engineered was pure politics. At the beginning of the week Norman Lamont seemed to have made it clear to the Treasury select committee that the exchange rate was an important factor in determining interest rate moves, remarks that had been read to suggest that there would be no further early fall in base rates. The modest strength in the pound during the week might have opened up an opportunity for a half-point cut, but this was not taken. On Wednesday the Bank of England did 26-day repos at unchanged rates, a move suggesting that it did not want to see an early fall. Sterling in any case had weakened in response to the Government's political plight, so a base rate fall seemed out of the question. Then, hey presto, came the 1 per cent cut.

Massaging policy

This really won't do. The decision may well be the right one, but this is a hopeless way to reach it. It signals to the markets, and for that matter to the country, that monetary policy is being massaged to suit the short-term political needs of the Government. There is nothing wrong with a central bank giving the markets occasional surprises to keep them on their toes, but these have to be formulated within the structure of a consistent policy. It further devalues anything the Chancellor says for him to give one indication at the beginning of the week and do the opposite at the end.

To want a reasonably strong pound (well, not too weak a one) is wholly sensible. Aside from the inflationary implications of an unnecessarily large devaluation, an overly weak currency will drive up long-term interest rates and so negate the advantages of lower short-term rates. It is also wholly sensible to want to take any opportunity the exchange rate allows to trim rates. But saying that the exchange rate is important and then apparently being prepared to provoke a new slide in the pound tells the markets things they would rather not know.

The other (and ultimately more important) worry is the deteriorating outlook for the European economy. Germany is the key. A few weeks ago most forecasters were still thinking of reasonable growth for 1993: at least 2 per cent, maybe more. Then the numbers started to come down into the 1 to 1.5 per cent region, and while the consensus is still 1.2 per cent people are now talking of less than 1 per cent. Now comes news of a sharp fall in German retail sales. It seems only a matter of time before the forecasts for Germany go negative. If that happens the rest of Continental Europe is dragged down too, and it hardly needs repeating that more than 60 per cent of UK exports go to the rest of the EC.

European recession

The possibility of Continental Europe actually moving into recession next year is not yet 'in the market'. It is the sort of thing people talk about over City lunch tables, rather as a year ago they pondered the possibility of Britain having another year of negative growth. But they have yet to believe sufficiently in the possibility to start to think through its consequences. These thoughts may, however, start to influence markets in the coming weeks.

One way in which one might gauge the concern over the Continental economies will be in attitudes to the mark. Foreign exchange markets for some years have been driven less by logic (and current accounts) and more by the 'feel-good' factor. Sterling boomed in the early 1980s partly in response to high interest rates but also thanks to the perceived success of Margaret Thatcher. Early Reaganomics had much the same effect on the dollar. The euphoria of unification has helped to drive up the mark. By the same token, both sterling and the dollar are now suffering from 'feel-bad'.

In a way, then, a weakening of the mark may be a danger sign, for it would suggest that the German economy really will deteriorate further. Europe will have lost its locomotive, for Germany is not just its largest economy, but its largest market. The plain arithmetic is that not all countries can rely on export-led growth, however competitive their currencies. The danger in Britain is that too cheap a pound will undermine domestic confidence more than it boosts exports.