Why Clarke must resist the siren voices calling for a lower pound
If markets have revalued sterling because they expect rates to be raised, its rise is no substitute for an increase in the cost of borrowing
Thursday 12 December 1996
Sterling has risen 12 per cent against the German mark since August and 17 per cent from its record lows in 1995. To City economists, almost to a man, the exchange rate appreciation reduces the need for an increase in base rates to keep inflation heading towards its target. A stronger pound makes imports cheaper in terms of sterling, which helps keep domestic inflation down. On top of that UK companies will find it harder to export because their prices will be higher in foreign currency terms, and the loss of competitiveness will tend to reduce GDP growth, limiting inflationary pressure.
The pound's rise will therefore be good for inflation and bad for exports and growth. Some analysts still hold to the rule of thumb published in an old Treasury working paper that a 4 per cent appreciation is equivalent to a 1 point rise in base rates. Some City folk espouse this view so passionately that the last regular meeting between Bank officials and economists working for the gilt-edge market-makers reportedly became unusually heated.
Much of industry is with the City on this, starting up the usual complaints about an "overvalued" pound, though the exchange rate is some 13 per cent below its ERM level in real and nominal terms and not yet back to its 1993-94 level against the mark.
The Bank of England takes a view which finds far more favour with the academic economics community - and, perhaps curiously, Treasury ministers. The Chancellor of the Exchequer has resolutely insisted the pound shall go where the market takes it. Chief Secretary William Waldegrave says British exporters are still at a competitive advantage.
The Bank's analysis, in the last Inflation Report and backed by research published in the Quarterly Bulletin, sees the exchange rate as the end product of forces in the UK and overseas economies. In the jargon, it is an endogenous variable - and not an instrument or target of monetary policy. The implications of the pound's appreciation for domestic inflation depend on why it has risen.
A currency appreciation can be caused by two types of influence: monetary and real. Real effects include factors such as higher oil prices for an oil-producing country, or a supply side improvement such as higher quality of output or improved productivity, or a demand side shift such as a step increase in demand for British goods because they are more fashionable. An appreciation due to monetary factors would reflect the expectation of either rising UK interest rates or falling overseas ones.
Suppose the pound's recent rise can be pinned on real factors. What effect would this have on inflation and exports? The revaluation of imports in sterling terms would contribute to a one-off decline in prices, which would reduce 12-month inflation rates for a year. But without additional monetary tightening, leading to "second-round" effects, it would make almost no difference to inflation in the medium term. No increase in base rates, no sustained fall in inflation.
As for exports, they might well grow despite the increase in the exchange rate, if the underlying cause were indeed something like higher quality or productivity. A recent, as yet unpublished, paper commissioned by the Treasury, by Peter Sinclair and Paul Brenton of Birmingham University, finds that there have been substantial improvements in quality in a number of industries - especially cars and electronics courtesy of inward investment - so increases in UK market share since 1980 have taken place without any depreciation or reduction in foreign currency prices.
Turning secondly to the monetary causes of a higher exchange rate, the Bank argues that if the currency market's expectations of either higher UK or lower continental interest rates are not met, sterling will adjust swiftly back to a lower level. Only if an early increase in base rates goes hand in hand with the pound's rise will the latter imply a lower path for future inflation. The Inflation Report notes that this is "a good example of a case where mixing together exchange rate and interest rates changes to assess the stance of monetary policy makes no sense". In other words, if the markets have revalued the pound because they expect Ken Clarke will have to raise base rates, the pound's rise is no substitute for an increase in the cost of borrowing.
It is true, in this case, that strong sterling combined with the increase in interest rates would hit exports along with the economy's overall growth. That is the point of raising interest rates - to cool an overheated pace of demand. It is perfectly reasonable to be concerned about the impact this policy would have on UK competitiveness. But the solution is not to avoid increasing base rates if that is what is needed given the Government's fiscal policy. The Bank of England is not allowed to argue - although the City could - that Mr Clarke should instead have opted for a much tougher Budget to keep economic growth down to a sustainable pace at a lower level for interest rates and the pound. The Bank's job is to advise on what level of interest rates will allow the Government to meet its inflation target, given the Government's fiscal stance.
Some commentators seem to think the Government should now be seeking a competitive devaluation. They look at the post-ERM experience, one of the few episodes in sterling's history when a big depreciation has not led to higher inflation. There is no doubt this gave British exports a huge boost. However, it did take place during a severe recession, and can not really be compared to any other devaluation since the Great Depression.
Professor Sinclair says: "I would be guarded in suggesting that sterling's appreciation now does not matter, but it is true that you can not generalise about the exchange rate. You can not take it as a policy parameter."
If the exchange rate were such a powerful influence on the UK's share of export markets, it would be hard to explain why that market share has declined steadily even though the pound has lost nearly three-quarters of its value against foreign currencies in 75 years. Britain's share of world trade has dropped from a sixth during the 1950s to a sixteenth by 1980. It stabilised during a decade which started with an enormous surge in sterling's exchange rate and for most of which the Government aimed to keep the pound stable rather than falling.
As the new Treasury research suggests, the quality of British exports could be equally important. A Conservative government certainly has no place listening to the siren voices of commentators arguing that the Chancellor - even one from a Midlands manufacturing constituency - should relax over interest rates so that the pound can fall again.
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