Strong pound `irrelevant', says George

According to the Bank of England, the pound's impressive climb since August does not imply that the Chancellor can afford to be a bit more relaxed about interest rates, writes Diane Coyle.

Mervyn King, the Bank's chief economist, said: "We do not believe in any rule of thumb relating changes in the exchange rate to changes in interest rates."

A higher value for sterling was no substitute for higher interest rates, he argued.

Mr King said the Bank had not sought an increase in interest rates simply to offset the sharp fall in the pound early in 1995.

This part of the Bank's analysis set the cat among the pigeons in the City, where many economists use the rule of thumb that a 4 per cent increase in the sterling index is roughly equal to 1 per cent on base rates. By this calculation, we have had the equivalent of a more than two-point rise in interest rates in three months.

The conventional argument is that a stronger pound will reduce inflationary pressures through lower prices for imports in sterling terms; and slower growth of exports.

The Bank says the first channel implies a one-off effect on the level of import prices which will reduce inflation in the short term only, and does not require a cut in interest rates.

In the medium term the inflationary impact depends on whether the rise in the exchange rate lasts, which in turn depends on why it took place. The inflation outlook will be better only if the reason was the expectation of tighter monetary policy in the UK.

If the Chancellor does not deliver on the policy, the pound is likely to fall again, according to the Bank.

"If a perceived temporary tightening of UK monetary policy - signalled by the rise in interest rates implied by short sterling futures to levels significantly above 6 per cent - is responsible for the appreciation, its persistence will depend on whether interest rates do indeed rise further," the report says.

Many in the City still disagreed. "The Bank's dismissal of the recovery in the pound as only a short-term influence is extreme," said Geoffrey Dicks of NatWest Markets.

The report initially sent sterling nearly a pfennig lower against the mark. It closed at DM2.4896 compared with the previous day's DM2.4979. Its index against a range of currencies lost 0.3 to end at 91.1.