Mr Clarke may not be so lucky next time

Kenneth Clarke, the Chancellor, must have been thanking his lucky stars for the perverse nature of the foreign exchange markets last week. Following his apparent rejection of the Governor of the Bank of England's base rate advice the previous Friday, sterling took a serious tumble, dropping to 2.175 against the mark and to a new low of 82.7 on the trade weighted index last Tuesday. At that moment, things looked grim for Mr Clarke.

In fact, sterling swiftly recovered. This was a lucky break for the Chancellor, since the weakness of the pound is the main reason why Eddie George, the Governor, believes that inflation may threaten to breach the top end of the official 1-4 per cent target range next year. But what exactly is the link between sterling and inflation? As the Bank pointed out last week, it is not as simple as it seems.

In the very long run, the change in the exchange rate tends to roughly offset inflation differentials between the UK and the rest of the world, so there is no large difference between the internal and external value of money. Many economists have deduced from this that a 1 per cent drop in sterling must eventually cause a 1 per cent rise in the domestic price level. But that need not be the case, since we do not know from this simple observation whether the exchange rate adjusts to inflation, or vice versa. If inflation is very low, perhaps the exchange rate adjusts upwards to validate it.

Nor are the "rules of thumb" usually quoted by economists necessarily enlightening. The graph shows the effect of "shocking" the Goldman Sachs inflation model with a sudden drop in the exchange rate. Models like this produce the rule of thumb result that a 5 per cent decline in sterling - roughly what we have seen this year - adds about 0.8 per cent to price inflation over 18 months. Similar models suggest that this can be offset by tightening in domestic monetary conditions which would follow a rise of 1 per cent in base rates. Hence the famous "four-to-one" rule - a 1 per cent base rate change is "equivalent" to a 4 to 5 per cent drop in the exchange rate.

However, these rules must be misleading, since sterling and base rates cannot be set independently of each other in equilibrium. The Inflation Report is very stern about this: "Floating exchange rates move because of changes in demand and supply in the market for foreign exchange, brought about by flows of capital and trade, and should not be treated as exogenous." In other words, exchange rates do not have a life of their own, but are determined by economic fundamentals in the domestic and foreign economies.

The Bank then tries to deduce which of several possible fundamental factors might explain the drop in sterling this year. Stripped down to essentials, there are two main possibilities - either the markets are reacting to expectations of easier monetary conditions at home, or to tougher monetary conditions overseas. In the former case, the decline in the exchange rate will be accompanied by a permanent rise in UK inflation. In the latter, there will initially be a rise in the UK price level, but this will eventually disappear completely as imported goods drop back in response to tighter monetary policy overseas.

After examining how interest rates and bond yields have moved at home and abroad, the Bank concludes that the overall behaviour of the financial markets is more consistent with the second explanation than the first. It believes that the main cause of sterling's weakness has been a tightening in foreign monetary conditions, especially in Germany and Japan. This in turn implies that the decline in the exchange rate will cause nothing more than a temporary blip in UK inflation.

What are we to make of these arguments? While it is always good to see rigorous economic logic being used to disentangle complicated market events, there is a danger of taking this too far. Foreign exchange markets do sometimes move for reasons which appear unconnected with long-term fundamentals, and this can in turn have feedback effects on the domestic economy.

For example, the decline in the dollar this year seems mainly to have been driven by a sudden collapse in confidence in the US economy, and sterling has been caught up in the backwash. If we choose to dress this up in technical jargon, we can say the "risk premium" on both the dollar and sterling have risen relative to other currencies. But all that really means is that we do not know why the exchange rates have shifted.

The trouble is that, once such a shift has occurred, it can have permanent effects on inflation before the foreign exchange markets spontaneously reverse themselves. As the Bank admits, the 5 per cent drop in sterling this year will temporarily push inflation towards the top of its 1 to 4 per cent target band next year. This could lead to increased wage pressures which the Government might choose to accommodate in a pre-election period. This would then show up in higher inflation expectations in the UK bond market, and the Bank's deductive method would conclude that domestic monetary conditions had been eased. But the whole process would have been triggered by a random shock to the exchange rate, a shock which UK policy did not immediately oppose and reverse.

For these reasons, it is dangerous to turn a completely blind eye to exchange rate declines, even if they are caused by irrational "bubbles" in the foreign exchange markets. The point is that a large enough depreciation in sterling can set in train events, especially in the labour market, which make it harder to follow a policy of monetary non-accommodation a year or two later. It is much less painful, and therefore politically feasible, to reverse the original exchange rate shock immediately.

These problems are made worse if the drop in the exchange rate undermines the credibility of the monetary framework, leading to a rise in domestic inflation expectations which might be much larger than is justified by a small change in sterling. Mr Clarke risked this when he took his base- rate gamble a week ago.

But so far he has been rescued by a series of random events overseas. The trend in world interest rates is clearly downwards, with the markets having apparently decided, for a short while at least, that a soft landing in the US is assured. This had encouraged global investors to search for high yielding assets, having largely missed the earlier rally in the "core" bond markets of the US, Japan and Germany. Several high-risk currencies which had been heavily oversold earlier in the year - the lira, peseta and franc, for example - were rallying strongly, and the mark was weakening. Sterling and gilts gained along with other "risky" assets.

By the end of the week, both the trade-weighted index and the gilt market were trading above the levels in place before the Chancellor's big gamble. But just because Mr Clarke has been lucky so far, we should not conclude that his decision was justified. Certainly, if he doubles his bet by spurning the Governor's advice again next month, he will need an even more outsize dose of luck to avoid, for a second time, an exchange market mauling.