What to expect with the strong pound here to stay

The only prudent expectation should be that there will be high interest rates for the next two to three years and sterling will remain strong

Let's forget about whether the Chancellor might have done something in the Budget to check the rise of interest rates and the pound. That is water under the bridge. Let's instead look at what is likely to happen to interest rates and the pound over the next two to three years, and see what consequences that might have on the UK economy.

There will presumably be another rise in interest rates this week, the main possible surprise being that the rise will be half a percentage point rather than a quarter. Let's assume that consumer demand continues to grow strongly through the autumn, fuelled partly by the windfall gains from building society conversions and partly from the rise in confidence encouraged by the continuing fall in unemployment. If that happens, expect rates to carry on rising through the end of this year, with the peak not reached until, at the earliest, the middle of next.

That peak? The market is currently thinking of 7.5 per cent, but if the evident momentum in consumption continues beyond the end of this year it is conceivable the big number will be an eight: the peak will be, say, 8.25 per cent rather than 7.75 per cent. But, in truth, we cannot know with any confidence the shape of the curve beyond the fact that we know there will be several rises in rates to come. The only safe assumption is that the UK will have high nominal interest rates for the next couple of years.

That is the assumption upon which the foreign exchanges have been working for the past six months, and obviously to some extent the rise in the pound is associated with that. But only to some extent: however odd it may seem to people steeped in memories of sterling weakness and scarred by the ejection from the ERM in 1992, the pound does at least have the attraction that it will almost certainly still exist in five years' time, not an assumption which can safely be made about other European currencies.

Some of the strength of sterling is interest-rate driven but much comes from suspicion of the available alternative currencies.

This leads to the present debate as to whether the pound's strength is sustainable. By historical standards it looks about 15 per cent overvalued (see graph) but it is not at the unsustainable level of overvaluation of the early 1990s, when the problem was less against the European currencies and more against the dollar. Besides, at that stage, the principal pressure was created by continental European interest rates being imposed on the UK, not the continental exchange rates.

Still, it certainly feels odd to see it at close to DM3.00 and $1.70. The mainstream view is that this will not last and within a year or so it will have fallen back to about DM2.50. There are two troubles with that view. One is that the people who are advocating it most strongly are those who failed to foresee the recent rise in the pound: because, in their view, it ought not to have happened in the first place, it ought not to last now. The other is that while they may be right, assuming that the pound will fall back is not a comfortable option if your business depends on this happening. You too may be right, which is fine; but if you are wrong, then your business will be in grave trouble.

So the only prudent expectation should be that not only will there be high interest rates for the next two to three years but that sterling will remain strong for that period, maybe longer if turmoil among continental currencies over European monetary union continues. What then?

There are two ways of approaching this question. One is to look at the macro-economic effects of a strong, maybe over-strong, pound. The trouble there is that past relationships do not necessarily hold: that sort of analysis failed to predict both the early fall in unemployment this recovery and the flat inflation which followed the devaluation of the pound in 1992. So it may be more helpful to look at the micro-economic consequences of a strong pound. Here are some.

We are going to see another wave of downsizing of large-scale industry. It may not be downsizing in output terms, but it will be a downsizing in employment. Large companies will be forced by sterling into another bout of scrutiny of their costs and there will be some fall-out in jobs as a result. There is nothing unusual about this happening at a time when output is rising: it is what has been happening in Germany over the past three years, despite strong export demand. But it will be at best unsettling and for some, inevitably painful.

There will be continued job growth, however, in the service sector. Total employment in the economy is still well below the peak of the 1988 cycle. That will suck back into employment many people who had decided to retire. Here there is a model in the US, employers have been forced to be more imaginative in the way they recruit new staff, and more energetic in the way they seek to retain it. There will also continue to be strong new business formation, partly because the functions shed by large companies will still need to be carried out. Outsourcing gives a great spur to new businesses. This will happen despite the rise in the cost of capital, with small companies pushed into seeking equity or risk-sharing, capital rather than bank finance. The boom in venture capital will continue.

Small businesses which sell abroad, like large, will be forced up-market. This will affect not just conventional exporters, but domestic companies which rely on tourists, as the UK will continue to be a relatively expensive destination.

In other words, we will see again the impact of previous periods of a high pound, but this time the effect will go much further down the scale. In previous foreign exchange cycles it was only really the large companies which were affected. In the next two to three years it will be small and medium-sized ones. For them there will be a prolonged period of good demand, but at squeezed prices: not a dreadful prospect, but quite a tough one.