Contrary to most people's belief, tighter budgetary policy generally keeps exchange rates down, because it encourages markets to expect that interest rates will be kept low. If, instead, the Chancellor cuts taxation in two weeks' time, the markets will fear a consumer boom, will expect higher interest rates, and will bid sterling higher. This in turn will hit the export sector, and further unbalance the current upswing, which is already biased towards services and away from manufacturing.
In this second best world, the key difficulty is whether to ignore the behaviour of the exchange rate when setting domestic interest rates. The Bank of England's Inflation Report published last week took a strong line on this question, arguing that the appreciating pound should have only a minimal effect on domestic monetary policy, and should certainly not be used as an excuse to avoid raising base rates further in the near future. The main plank in the Bank's case is that sterling should not be seen as an independent actor on the scene, but that its behaviour should be viewed as being determined by other economic variables, such as interest rates, supply side variables (such as oil prices) and the like. Since these variables also determine the inflation rate, it follows that the exchange rate and inflation are actually co-determined by other factors - which in turn implies that changes in the exchange rate cannot independently "cause" changes in inflation.
Some will claim that the Bank is taking a tougher line now that the exchange rate is rising than it did in the spring of 1995, when sterling took a nose-dive. At that time, the Inflation Report reacted to the drop in the pound by substantially raising the 12-month forecast for retail prices, and by asking the Chancellor to raise base rates so that any second round effects on wages and prices would not be "accommodated" by monetary policy. By contrast, the recent rise in the exchange rate has not seen any downward revision to the Bank's inflation projection, and the policy recommendation is now to ignore the exchange rate and raise base rates further in coming months.
To the Bank's opponents, this is another example of how Threadneedle Street always errs on the hawkish side of any debate about monetary policy. But the Bank claims it is in fact being completely symmetrical in its approach. The reason why the inflation forecast has not been brought down this quarter as sterling has risen is that domestic inflationary forces have worsened considerably since the August Report. These domestic forces have added at least 0.7 per cent to the underlying inflation rate in the current quarter, and this is more than enough to swamp any permanent beneficial effects from a higher exchange rate. Hence further base rate rises are needed.
The Bank believes that three factors may have been responsible for the recent rise in sterling. The first is a rise in the "equilibrium real exchange rate", largely driven by rising oil prices. This explains about half of the total rise in sterling. The second factor is a loosening in monetary conditions overseas, which explains a quarter of the rise. The third is an expected tightening in domestic monetary conditions (ie a market expectation that base rates will rise in future), and that too explains about a quarter of sterling's gain. According to the Bank, only the last of these factors will lead to a permanent drop in inflation, and that will only happen if the expected rise in base rates is actually delivered by the authorities, along the path which is currently anticipated by the financial markets. The upshot of this analysis is that the need for base rate increases has not been eliminated by the rise in sterling.
This approach stands in sharp contrast to the view of some other central banks, notably the Bank of Canada. The latter explicitly takes account of exchange rate movements when setting domestic interest rates, and has actually formalised the process by calculating a monetary conditions index, in which a 1 percentage point change in interest rates is given the same weight as a 3 per cent change in the exchange rate. This procedure, of course, makes no sense if behaviour of the exchange rate is indeed primarily determined by the level of interest rates at home and abroad, but it would make more sense if the exchange rate is subject to "exogenous" shocks which are unrelated to other economic fundamentals.
If, for example, the recent rise in sterling could be attributed to a sustained drop in the risk premium on UK assets, or even to a self-fulfilling fad in the foreign exchange markets, then it might make more sense to treat it as a substitute for further increases in base rates. So far, it is difficult to argue that this is the case. But it seems quite likely that the strength of sterling will go further in coming months, since the UK is the only major country which is growing rapidly at present, and this is acting as a magnet for speculative capital inflows. With countries such as Japan and Switzerland holding their interest rates at exceptionally low levels, this force will not quickly disappear and could easily gather momentum. It could add up to quite an economic shock, and could certainly have a powerful short-term effect on inflation.
The graph, prepared by David Walton of Goldman Sachs, shows what might have happened to inflation if the exchange rate had remained unchanged at the level reached at the end of 1994. Up to now, actual inflation has been considerably boosted by the drop in sterling which happened last year, but the effect is about to turn the other way, and from the early part of next year the path for inflation will be sharply held down by exchange rate effects. For a time, this may be enough to keep inflation below the Government's target, but the target is still likely to be exceeded before the end of next year, and the main trend is probably now upwards.
This inflation profile supports the Bank's case for base rates to rise further, unless there is a really marked additional rise in sterling from present levels. If that occurs, then the policy choices will not be enviable ones. Base rate rises could cause the pound to overshoot upwards; but their absence could result in a rampant consumer boom.
As the Bank hints, the route back to the first best world would be for the Chancellor to slow domestic demand by tightening fiscal policy in the Budget. But, in this pre-election period, the Bank might as well be asking for the moon.