Too early for a cocktail of interest-rate moves

The hand-wringing over the machinations of the foreign exchanges continues, the latest example being the European Union finance ministers' meeting in Brussels yesterday. But we are not yet at the stage where the finance ministers and central bankers are sufficiently frightened to be prepared to do anything to help.

This raises two central questions. Under what circumstances might the authorities of the main developed countries feel their economies were sufficiently threatened by currency instability that they would need to act? And what might they then do?

At the moment, only two of the Group of Seven large developed countries are running scared: Japan, because its currency is excessively strong, and Italy, because its is excessively weak. Japan is frightened because the continued rise of the yen has two effects. The direct effect is that it prices further chunks of the Japanese economy out of world markets. For example, car exports from Japan are the lowest for 10 years, while the US has just overtaken Japan to become again the world's largest car manufacturer.

The indirect effect is that the pressure on the business sector is pushing the entire economy back into recession, with the result that Japan is the only important economy not to have made a secure recovery from recession. And Italy is frightened because the measures it has taken to tighten its fiscal position, so far at least, are failing to re-establish its credibility in international markets.

Among the other countries there is concern but so far no fear. Thus the US is certainly concerned that the dollar is weak, but while that concern does not feed much into its own price levels (helped by the slight easing of commodity prices, most of which are still in dollar terms) it will not feel the need for any action. Equally, while Germany is concerned about the surge of the mark, that concern is so far quite muted. In Germany there is often a shading of difference between the views of the Bundesbank and those of the German government, but for the moment these will be much the same.

The Bundesbank's view, insofar as there is a single house view, will be that the current strength is a short-term market reaction which does not at this stage demand action. Only if the rise in the exchange rate had the effect of imposing an over-tight monetary policy would the Bundesbank feel the need to act. The German government, on the other hand, will be receiving signals from the business community about the potential damage from the strong mark. While export demand continues to be strong, as it is now, these signals will not be sufficiently powerful to affect policy.

As for the other main countries, France and Britain are preoccupied with other things: France with the impending presidential election, Britain withcontinuing warfare within the Tory party. Only were the weakness of the franc and the pound to become really alarming would there be the political will for concerted action to check the falls.

So while it is not difficult to envisage a set of circumstances that would lead to concerted action to steady currencies, we are quite a long way from that at the moment. The dollar is not yet sliding into a black hole. If you want a trigger level against the mark, maybe the dollar plunging well below DM1.30 would get a concerted reaction. But we are not there yet.

Suppose, though, the fall does continue, what credible reaction might there be? It would be the usual cocktail. There would have to be a notional cut in German interest rates. This could be justified on the domestic grounds that, allowing for the rise in the mark, such a fall did not constitute any net change in the overall monetary stance. There have been half hints that some token cut in rates may be on the cards, and any further easing of world commodity prices would give a little more justification. One of the indicators of inflation to which the Bundesbank pays attention is its index of commodity prices in mark terms. The combination of the strong mark and the fact that dollar-denominated prices seem to have peaked will be making this indicator look better than it has for many months.

At the same time there would have to be a rise in US rates, for without that no policy to steady the dollar will be credible. Such a rise is not as remote a possibility as many professionals in the US markets have maintained. In so far as past economic cycles are any guide, the peak in US rates is likely to come in the second half of this year: on precedent we have not reached it yet.

The other countries do not matter. Concerted action would have to include the other members of the Group of Seven, so there would be inevitably interest rate rises in France, Italy, the UK and Canada. Japan would have to make some further efforts at boosting domestic demand. But these countries will not be in the driving seat as far as decision-making is concerned: the key players are Germany and the US, and until they feel the need to act nothing will happen.

Such a cocktail of concerted interest-rate moves, supported naturally by intervention, would be effective provided the markets themselves felt that the plunge of the dollar had gone far enough. What would this require?

Two things can sensibly be said about any large speculative swing like this. The first is that sooner or later it will play itself out: dealers will decide that the quality of dollar assets is not so bad after all, and that the quality of mark assets may not be quite all it has been cracked up to be. (The intellectual basis for the mark as a safe haven is pretty thin, given that German wage rates, for example, are now rising faster than British for the first time in 25 years.) The second is that the market's invention of the flight into quality is sufficiently recent for it to have some life in it for a while yet.

What would give the cocktail real zest would be for it to be coupled with an indication the G7 felt a communal responsibility for currency stability. This need not take the form of a return to the unpublished target zones for the main currencies, the system agreed in the Louvre Accord in 1987. But even having a sense of what the central banks thought was a reasonable rate for the main currencies would help steady the markets.

This is an issue that matters. Yesterday's announcement from Brussels that the International Monetary Fund's interim committee would discuss currency surveillance is a modest first step. But anyone who has followed such deliberations over the years will be aware that a technical paper by the fund is no substitute for political will by the main players - and that means the will to carry out the appropriate fiscal and monetary policies, not just to co-ordinate market intervention. The tragedy is that target zones worked quite well for a while, but they only worked because policies were co-ordinated. If the IMF discussions bring this fundamental truth into the open they will be doing something useful. But do not expect too much, for the main players are not yet worried enough to act.