Sterling takes a breather in rates debate

It should have been no surprise that there was a pause in the recent steep climb in the pound on a day when the economic debate hinged almost entirely on the strength of the exchange rate. Its index against other currencies closed at the same level, 98.2, as the previous day, writes Diane Coyle.

Even so, sterling has increased by 16 per cent in value since last August, and remains at about the level from which it tumbled out of the exchange rate mechanism on 16 September 1992. The exchange rate is the fault-line currently dividing the interest rate hawks from the doves.

There is no question that a strong pound will tend to reduce inflation and erode the UK's trade position. What is hotly disputed, in the corridors of power and City alike, is whether it is therefore a good enough substitute for higher interest rates.

That is certainly Kenneth Clarke's view. He has emphasised the impact the exchange rate will have on exports and manufacturing as a counterweight to robust consumer demand. The business community agrees, with a succession of companies this year having complained about weaker export prospects.

Ian Peters, deputy director general of the British Chambers of Commerce, said yesterday that a rise in base rates would "fuel the fire" under the pound.

Mervyn King, the Bank of England's chief economist, said the Bank's new inflation forecast took account of sterling's strength. This was why he had revised down the forecast for the next few months. He added that the exchange rate appreciation posed a dilemma: domestic demand would expand too fast if the Chancellor did not raise rates, or export demand would suffer if he did.

A lengthy section of yesterday's Inflation Report sets out the textbook analysis of a strong exchange rate. The Bank reckons a mix of reasons lies behind the pound's current strength: the expectation that UK interest rates will rise relative to US and European rates, the impact of government budget cuts on the Continent in reducing market interest rates across the Channel, and the increase in oil prices.

The Bank's forecast incorporates both the one-off effect of a higher exchange rate on the price level via lower import prices, reducing measured inflation rates for 12 months, and the longer-lasting impact via reduced exports and higher imports. But it assumes, based on financial market expectations, that sterling's index will fall to about 91 within two years. Mr King said: "There is nothing remotely odd or controversial about this view."

Roger Bootle, chief economist at HSBC Markets and one of the Treasury's "wise persons", disagreed. "These supposedly one-off shocks have a way of carrying on. The pound will be a powerful disinflationary force," he said.