Academic journal article National Institute Economic Review

The UK Economy

Academic journal article National Institute Economic Review

The UK Economy

Article excerpt

Section I. Recent Developments and Summary of the Forecast

The sterling exchange rate was unusually stable in the two years following its departure from the ERM in September 1992. In effective terms it fluctuated within a fairly narrow range around an average of about 89 on the new effective exchange rate index and this was approximately the level at which it ended 1994. Since then it has depreciated by over 5 per cent and at the time of writing (11 May) there is some uncertainty as to whether it will fall further. This largely unexpected depreciation is of sufficient size to influence the development of the UK economy and in particular to increase the amount of inflationary pressure at a time when there are doubts about whether monetary policy has been tightened enough to deal with that which already exists.

Other things being equal a sustained change in the effective exchange rate can be expected to add a similar amount to the level of prices over a number of years. Our estimates indicate that a 5 per cent exchange rate devaluation would add about 1.8 per cent to the rate of inflation in the first year, 1.9 per cent in the second year and 1.2 per cent in the third year. In practice the full effect of a change in the exchange rate depends on whether it is sustained and whether any other influences on prices move to offset its effect. Monetary policy in particular can be tightened to ensure that the effect of the depreciation is muted.

It is also important to take account of the causes of the fall in the exchange rate. For example this would not contribute to inflationary pressure in the UK if the effective exchange rate were itself responding to lower price pressure emanating from the rest of the world. There is evidence of some weakening in external inflationary pressure: some commodity prices such as wheat and coffee are likely to be lower than they were last year and others such as copper and aluminium are not now expected to be as high as previously thought. These changes reduce the impact of the sterling depreciation to a small extent but do not offset it. Other external pressure on UK inflation is likely to have intensified this year.

The movement in sterling since the end of last year has been less pronounced than the change in some other currencies. The dollar effective exchange rate has depreciated by close to 10 per cent, the D-mark effective exchange rate has risen by about 5 per cent and there has been a larger appreciation in the yen effective rate. The main movement therefore has been a shift in the dollar-yen rate with the other currencies tending to follow one of these currencies to a greater or lesser extent.

The weakness of sterling within this generalised realignment of currencies is something of a puzzle in that the strong performance of the traded goods sector over the past year is not indicative of a currency that is over-valued. More recently, political risk has intensified following the local election results and the failure to raise interest rates on May 5 has raised doubts about the strength of the government's commitment to its inflation target.

The overall response of world prices to exchange rate movements of this type will ultimately depend on how policy in the various countries responds to the exchange rate shock. This is explored fully in the World Economy chapter in this Review. It appears that some countries have reacted to the appreciation of their currencies by loosening monetary policy. Since the beginning of the year interest rates have been reduced in the major countries which have experienced an effective exchange rate appreciation with market interest rates falling by close to one percentage point in Germany and Japan. Market interest rates are also marginally lower in the USA than they were at the turn of the year. The analysis reported in Box A of the World Economy chapter suggests that the response of the monetary authorities to recent large exchange rate changes has had the effect of loosening monetary policy in the world as a whole. …

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