View from City Road: Under the shadow of a large trade deficit

The Treasury was quick off the mark to dash any hopes that yesterday's surprise cut in the German discount rate would be used to justify lower British base rates. With the green shoots of recovery becoming increasingly verdant, the Chancellor is instead content to see a rising pound. This helps keep inflation under control and makes it cheaper for the Bank of England to rebuild its depleted reserves by selling sterling.

The Bundesbank rate cut and the surprise March fall in British unemployment gave the pound a double fillip, pushing it to a 13-week high of DM2.4868. As long as Britain's recovery strengthens and Germany's recession deepens the trend should continue, although the experience of the US is an important reminder that runs of good economic news are prone to be interrupted.

The Treasury's enthusiasm for a rising pound is in large part explained by the inflation target it set itself in the aftermath of Black Wednesday. On the forecast of 1.25 per cent growth this year in the Budget, underlying inflation was expected to remain within a whisker of its 4 per cent target ceiling for two years. But the Budget forecast is being seen by a growing number of economists as excessively cautious. Certainly no one - the Treasury included - expected to see two successive falls in unemployment.

If the recovery continues to accelerate and the falls in unemployment are sustained, inflation is likely to move above its target ceiling within a few months. Falling unemployment makes people less fearful for their jobs and encourages them to push for higher pay increases.

This suggests that the Treasury will be happy to see the pound rise further still, although a dark cloud remains. In July we get our first glimpse of the full trade figures for the first half of the year. A surprisingly strong recovery may portend an alarmingly large trade deficit, a problem that a strong pound will only make worse.

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