The Bank of England and Mervyn King, its deputy governor, are more modest. The Bank freely admits to not understanding why the exchange rate has risen as far as it has. None of the obvious explanations - stronger UK growth, rising interest rates, or the pound as a safe haven against a weak euro - can fully account for sterling's climb during the past 18 months. Equally, while everybody agreed that sterling was overvalued given the economic fundamentals, there is no obvious reason why it should have started falling with such dispatch from its unreasonable height just over a month ago.
The one thing that can certainly be discounted as the catalyst is the intervention of George Soros. Huge numbers of people and funds have been engaging in the purchase of put options - the right to sell sterling at a lower rate in three months' time. The $6-8bn Soros is reported to have spent was a drop in this ocean, even if it is true that the arch-financier did catch the tide of market sentiment exactly on the turn. That in itself seems to be in doubt, with some traders claiming that in point of fact he was relatively late into the trend. If true, he's obviously losing his touch.
However, the mere fact that he is being acclaimed in some quarters as the saviour of the British economy by riding to the rescue of exporters and pushing sterling lower sheds an illuminating light on why the outlook for the exchange rate is so important at the moment.
The strong pound is cited by hawks on the Bank of England's monetary policy committee (MPC) as an important reason why inflation has stayed not too far above its target. Domestic demand is belting away at a still- uncomfortable rate. Other inflationary pressures are starkly revealed by yesterday's shock earnings figures. Without falling costs for imported goods and materials, retail price inflation would have been significantly higher for the past two years.
However, if the pound falls now, it does not give the hawks an open and shut case for raising interest rates. Quite the reverse if the weaker exchange rate anticipates economic slowdown and market expectations of the lower interest rates that will result. But if the depreciation is due to, say, a change of heart about the strength of the new euro, or to the likelihood that domestic inflationary pressure will worsen the balance of payments, it is reason to counteract it with tighter monetary policy.
The point is that there is no hard and fast connection between the exchange rate and interest rates. The long term interests of the UK economy, and this goes for its exporters too, are best served by keeping a steady eye on the inflation target, and commensurate with the parallel aim of achieving sustainable growth, adjusting interest rates to hit it. It is members of the MPC, and not the speculators, who have the interests of UK PLC most at heart.Reuse content