Economics: Strong pound will cut rates further

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The Independent Online
HERE IS a trick question: given that Nelson Mandela's African National Congress has a reputation for militancy and is heavily influenced by members of the South African Communist Party, what would you expect its monetary policy to be? Inflationary? Irresponsible? A little like that of Viktor Geraschenko, governor of the Russian central bank?

You would be quite wrong. One of the most intriguing interviews I had at the Davos world economic forum was with Trevor Manuel, the ANC's economic spokesman, widely tipped as a future South African finance minister. Mr Manuel, who is a level- headed and impressive man, advocates central bank independence on the New Zealand model: the government would give the South African bank a contract to hit a low-inflation target.

This is perhaps not as surprising as it seems. Left-of-centre parties usually face fierce pressures for financial irresponsibility, and their leaderships find it quite convenient to be able to blame some outside force - whether the International Monetary Fund or an independent central bank - for policies that privately they would happily pursue themselves. This may not be noble, but it is politics.

For similar reasons, I would not be at all surprised if Labour's modernising shadow Chancellor, Gordon Brown, moved in the same direction. The Liberal Democrats already want to free the Bank of England. For Labour, the electoral advantages of advocating central bank independence are considerable, because it would help to dispel the lingering perception that the Opposition is less responsible, economically, than the Government.

It would also create the political conditions for an effective and stable monetary policy. As Eddie George, the Governor of the Bank of England, pointed out last week, he would not want to be given responsibility for monetary policy unless there was a consensus for low inflation. That would merely be a poisoned chalice.

Mr George is likely to be a figure of increasing power. He is a tough-minded individual who now has a clear mandate to comment on whether monetary policy will achieve low inflation. The next inflation report will be published on Tuesday. Mr George is likely to grow in stature, if only because he will outstay many a revolving chancellor. Like Montagu Norman in the inter-war period, force of character and length of tenure will count for a lot.

In the view of past colleagues, Mr George also still has a touch of the old-fashioned monetarist, which is one reason why he and Kenneth Clarke did not cut interest rates last week. The narrow money measure of notes, coin and bankers' cash at the Bank of England - M0 - grew by 5.8 per cent over the year to February, and is accelerating above its 0-4 per cent target. M4 - which adds bank accounts - was also speeding up at 5.4 per cent, although still in its 3- 9 per cent monitoring range.

The Chancellor is clearly more impressed by the evidence of strong domestic demand, and feels there is no case for a further stimulus at present. In Davos he said that he would prefer the recovery to lean towards net exports rather than consumer spending. This makes sense when we are still running a balance of payments deficit despite depressed imports near the bottom of the cycle, and when the deficit may be larger than the official figures show.

Nevertheless, my own view is that Mr Clarke was unwise not to cut interest rates again while he still had the chance to influence the level of mortgage rates paid by people whose payments are fixed once a year: particularly the 1.2 million people with the Halifax, whose payments are set on the basis of interest rates at the end of January. But that opportunity has now been missed.

So will interest rates come down again, and by how much? There are now two economic triggers for UK rate cuts. The first would be a sharp slowdown in the wake of the tax increases in April, which are still likely to have a greater impact than some officials suppose. However, any growth pause is unlikely to become apparent before May or June, simply because of the usual delays in the collection and preparation of statistics. The second trigger for rate cuts - a rise in sterling - is likely to come sooner.

You do not have to believe what the Chancellor says about his fondness for manufacturing or his enthusiasm for a recovery buoyed by net exports to expect him to react adversely to a rise in the pound. Last week, the Treasury published the first tentative piece of evidence that Mr Clarke had sanctioned intervention to stop the pound rising: the official reserves of foreign exchange rose by an underlying dollars 205m.

My guess is that the Chancellor is very happy with sterling at around its current level. On the trade-weighted index against all our partners' currencies, the pound is nearly 10 per cent below its level when we left the exchange rate mechanism, and 6.6 per cent higher than its average level in February, the post-ERM low. A fall would raise the sterling price of imports and make the 1-4 per cent inflation target more difficult to meet, while a rise would threaten the net export-led recovery.

This level of sterling, incidentally, is exactly where the National Institute of Economic and Social Research believed that we should have entered the exchange rate mechanism. Using the concepts developed by John Williamson, the NIESR argues that sterling needed to be some 10 per cent lower than its ERM rate in order to bring into balance both the external trade accounts and supply and demand in the labour market*.

If my hypothesis about the Chancellor's preferences is correct, he will increasingly seek to counteract any pressures for a rise in sterling. His first weapon may be intervention, but his second will have to be interest rate cuts. So the next question is whether there will be upwards pressure on sterling through this year, and by how much.

After five years heading down, US interest rates began last week to edge upwards, and will pull the dollar up against European currencies. But the US is a much smaller trading partner for Britain than continental Europe: with German interest rates still falling, sterling is likely to rise on its trade-weighted index this year unless the Chancellor allows sterling interest rates to follow German interest rates down, at least in part.

After all, sterling's rise over the last year has been almost entirely due to its strength against the mark, and is perfectly explicable in terms of the steady fall in German interest rates relative to British ones: British interest rates were 2 percentage points below German rates last February, and are now a little more than 0.5 percentage points below. If German rates begin to edge down again, the Chancellor may have to cut by nearly as much to avoid a sharp rise in sterling.

So our interest rate outlook may depend, once again, on the Bundesbank. The German central bank's caution has been due in part to its worries about the recent sharp rises in German money supply, and in part due to concern about the weakness of the German mark on the foreign exchanges. It will be happy if other European countries use their latitude within the new wide bands of the exchange rate mechanism to edge interest rates down again, thereby strengthening the mark.

But the Buba will find it increasingly hard to resist the calls for a further easing, especially since German inflation is now down to 3.4 per cent in January from 3.7 per cent in December - and 4.8 per cent as recently as last March. German inflation looks as if it is heading towards the 2-2.5 per cent level with which the Bundesbank declares itself satisfied.

The Deutsche Bank team led by Norbert Walter, for whom I have considerable respect, argues that German interest rates will trough at just under 4 per cent by the end of this year, and that there will be a 0.5 percentage point cut in rates in a fortnight, or at the beginning of March. If this is right, the trigger for a British rate cut should be in place by the spring.

* 'When the time was right? The UK experience of the ERM' by Ray Barrell, Andrew Britton and Nigel Pain, NIESR working paper.

(Graphs omitted)