Exchange rate considerations should be played down in economic policy-making, according to the Bank of England. But, warns David Smith, there are limits to a policy of laissez-faire.
Most readers of this column, I suspect, have a straightforward attitude towards the exchange rate. When it is rising, it squeezes export margins and can make some overseas markets enviable, at least temporarily. When it is falling it pushes up the cost of imported materials, components and finished products and can produce a nasty double whammy of higher interest rates as well. Currency stability is thus a happy medium. Sterling is at its best when it is doing nothing.
Economists, not surprisingly, have a different view. In fact, as you might expect, they have lots of different views. A rising exchange rate can be good. A stable one, in certain circumstances, can be bad. A falling currency can be good or bad, depending on the conditions in which it occurs.
Strong pound - virility symbol?
The pound's strong rise during last year, which continued into this year, could be interpreted either as an international vote of confidence in Britain's economic renaissance - and thus something of a virility symbol - or as a harbinger of the higher interest rates that may be needed to control rising inflation. It could therefore either be good, as a dampener on an economy threatening to grow too fast, or bad, shifting growth away from exporters and towards importers and consumers at precisely the wrong time.
Perhaps the most surprising recent piece of analysis has come from the Bank of England which, in its quarterly inflation reports, has argued that, as far as economic policy decisions are concerned, the exchange rate should, in the normal course of events, be ignored. Thus, if there is a need to raise interest rates to stop consumers from increasing their spending too rapidly, it should happen, according to the Bank.
I am not, I should say, totally convinced that the Bank would, in practice, be so even-handed about the exchange rate in all circumstances. Raising interest rates, even if sterling is appreciating, is feasible but lowering them if sterling is under pressure might not be considered fitting for an institution committed to delivering the Government's inflation target.
Even so, it is a challenge to the conventional wisdom. It is common, for example, to view changes in the exchange rate as a substitute for interest rate changes, and for monetary policy to be seen as a combination of the pound's level, and that of base rates. Broadly speaking, a rule of thumb that was fashionable in the 1980s (but which both the Treasury and Bank now disown), is that a rise of 4% in the average value of sterling is similar in its broad effects as a point on base rates, and vice versa in the case of a falling pound.
So why should the pound be ignored, when its effects, as any industrialist will testify, can be considerable? The Bank argues that some sterling changes reflect, not events in Britain but those overseas, that all such changes are quickly reversible, and an appreciation in the currency that reflects market anticipation of higher base rates cannot be a substitute for a rate rise. If the rate rise is not forthcoming, confidence in the credibility of UK economic policy will be hit, and the pound will quickly fall, perhaps to below the point at which it started.
A philosophy of ignoring the exchange rate also has support from recent experience. The general expectation when sterling dropped out of the ERM was that through the normal route of higher import prices, inflation would rise sharply. It did not, because conditions in Britain were depressed and companies in countries exporting to Britain - particularly those in Europe - were prepared to cut back on their profit margins rather than try and sell instead into their own depressed markets. The pound's strong rise in 1996, meanwhile, might have taken the edge off export growth but certainly did not halt it. Nor did it prevent inflation from running above the official 2.5% target.
The pound's real performance
It is, as with so many of things, a question of degree. The above chart shows the pound's 'real' (ie inflation-adjusted) performance during the floating-rate era. What this means is that if UK inflation is three percentage points above the average of trading partners in a given year and the pound drops by 3%, the real exchange rate is unchanged. Only if the pound falls or rises more than is required to compensate for inflation differences does the real exchange rate fall or rise respectively.
The recent rise, therefore, needs to be put into perspective. Taking the 1970-95 real exchange rate as a benchmark, sterling was undervalued in the post-ERM period but has just become slightly, but certainly not significantly, overvalued. The pound's recent periods of significant overvaluation - 1990-2 (the ERM period) and 1980-1 - were both times when recession and high interest rates occurred together, the latter the proximate cause of the former.
Dangers come in cycles
Mostly, therefore, sterling has returned to something like normality after the 1990s experience when it was first overvalued and then undervalued. In this respect, it is right for the Bank and Treasury to have taken a laissez-faire attitude to its strength, and rejected a policy of active exchange rate management by, for example, cutting interest rates to restrain it.
There is, however, a limit to laissez-faire. In an open economy like Britain, ignoring the pound entirely can be dangerous. The Bank of England, despite its recent pronouncements, is doubtless keeping a weather eye on sterling.
If the currency's over-valuation threatened to reach 1980-1 proportions, or its more muted 1990-2 echo, that would be both damaging and unwelcome.
If it came at a time when, for cyclical reasons, the economy was slowing anyway, it could produce something more serious. A return to the wilder fluctuations in sterling, up or down, will always signal a major health warning for businesses. We have been there before.