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.

News
Jacqueline Bisset has claimed that young women today are obsessed with being 'hot', rather than 'charming', 'romantic' or 'beautiful'
people
Sport
New Zealand fly-half Aaron Cruden pictured in The Zookeeper's Son on a late-night drinking session
rugby
News
Liam Payne has attacked the media for reporting his tweet of support to Willie Robertson and the subsequent backlash from fans
peopleBut One Direction star insists he is not homophobic
Arts and Entertainment
A bit rich: Maggie Smith in Downton Abbey
tvSeries 5 opening episode attracts lowest ratings since drama began
PROMOTED VIDEO
Arts and Entertainment
Ben Affleck stars as prime suspect Nick Dunne in the film adaptation of Gone Girl
filmBen Affleck and Rosamund Pike excel in David Fincher's film, says Geoffrey Macnab
News
news
Arts and Entertainment
Lena Dunham
booksLena Dunham's memoirs - written at the age of 28 - are honest to the point of making you squirm
Life and Style
fashionThe supermodel on her career, motherhood and Cara Delevingne
News
i100
Life and Style
A new app has been launched that enables people to have a cuddle from a stranger
techNew app offers 'PG alternative' to dating services like Tinder
Sport
Greg Dyke insists he will not resign as Football Association chairman after receiving a watch worth more than £16,000 but has called for an end to the culture of gifts being given to football officials
football
News
people
News
ebooksAn unforgettable anthology of contemporary reportage
Arts and Entertainment
Jake Quickenden sings his heart out in his second audition
tvX Factor: How did the Jakes - and Charlie Martinez - fare?
Sport
premier league
Sport
Frank Lampard and his non-celebration
premier leagueManchester City vs Chelsea match report from the Etihad Stadium
Arts and Entertainment
Rachel, Chandler and Ross try to get Ross's sofa up the stairs in the famous 'Pivot!' scene
tv
Arts and Entertainment
'New Tricks' star Dennis Waterman is departing from the show after he completes filming on two more episodes
tvOnly remaining original cast-member to leave crime series
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

COO / Chief Operating Officer

£80 - 100k + Bonus: Guru Careers: A COO / Chief Operating Officer is needed to...

Senior BA - Motor and Home Insurance

£400 - £450 Per Day: Clearwater People Solutions Ltd: **URGENT CONTRACT ROLE**...

Market Risk & Control Manager

Up to £100k or £450p/d: Saxton Leigh: My client is a leading commodities tradi...

SQL Developer - Watford/NW London - £320 - £330 p/d - 6 months

£320 - £330 per day: Ashdown Group: The Ashdown Group have been engaged by a l...

Day In a Page

A roller-coaster tale from the 'voice of a generation'

Not That Kind of Girl:

A roller-coaster tale from 'voice of a generation' Lena Dunham
London is not bedlam or a cradle of vice. In fact it, as much as anywhere, deserves independence

London is not bedlam or a cradle of vice

In fact it, as much as anywhere, deserves independence
Vivienne Westwood 'didn’t want' relationship with Malcolm McLaren

Vivienne Westwood 'didn’t want' relationship with McLaren

Designer 'felt pressured' into going out with Sex Pistols manager
Jourdan Dunn: Model mother

Model mother

Jordan Dunn became one of the best-paid models in the world
Apple still coolest brand – despite U2 PR disaster

Apple still the coolest brand

Despite PR disaster of free U2 album
Scottish referendum: The Yes vote was the love that dared speak its name, but it was not to be

Despite the result, this is the end of the status quo

Boyd Tonkin on the fall-out from the Scottish referendum
Manolo Blahnik: The high priest of heels talks flats, Englishness, and why he loves Mary Beard

Manolo Blahnik: Flats, Englishness, and Mary Beard

The shoe designer who has been dubbed 'the patron saint of the stiletto'
The Beatles biographer reveals exclusive original manuscripts of some of the best pop songs ever written

Scrambled eggs and LSD

Behind The Beatles' lyrics - thanks to Hunter Davis's original manuscript copies
'Normcore' fashion: Blending in is the new standing out in latest catwalk non-trend

'Normcore': Blending in is the new standing out

Just when fashion was in grave danger of running out of trends, it only went and invented the non-trend. Rebecca Gonsalves investigates
Dance’s new leading ladies fight back: How female vocalists are now writing their own hits

New leading ladies of dance fight back

How female vocalists are now writing their own hits
Mystery of the Ground Zero wedding photo

A shot in the dark

Mystery of the wedding photo from Ground Zero
His life, the universe and everything

His life, the universe and everything

New biography sheds light on comic genius of Douglas Adams
Save us from small screen superheroes

Save us from small screen superheroes

Shows like Agents of S.H.I.E.L.D are little more than marketing tools
Reach for the skies

Reach for the skies

From pools to football pitches, rooftop living is looking up
These are the 12 best hotel spas in the UK

12 best hotel spas in the UK

Some hotels go all out on facilities; others stand out for the sheer quality of treatments