Economic Prospects for the UK and Policy Recommendations
Weale, Martin, Young, Garry, National Institute Economic Review
Much the most important economic change of the last quarter has been the continuing rise in the exchange rate. We commented in October that if the high level of sterling persisted then this would provide an element of monetary tightening and would reduce the need for an interest rate rise in order to meet the inflation target. Since October sterling has risen further. At the time of writing, the pound is at US$1.63 and DM 2.67 as compared with US$1.55 and DM2.30 only last August, and the trade-weighted index has risen by around 14 per cent.
Possible Causes of the Rise in Sterling
There are a number of possible factors which may explain the rise in sterling since the summer. First of all there is probably a view that the British economy is performing better than the economies of other major European countries in terms of unemployment and economic growth. This may be compounded by the uncertainty over the plans for Monetary Union and the fear that it may be a destabilizing influence, particularly in France. These two factors have combined to generate favourable sentiment towards sterling, raising demand for the currency.
Secondly there is an increased interest rate differential between UK and other countries. This may have been compounded by expectations of a rise in UK rates. We discuss this below. We agree that if, as the Bank of England has argued, expectations of a rise in UK rates are important, those expectations will have to be realised if the strength in sterling is to be maintained.
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It is less likely that the increase is due to an improvement in supply conditions in the UK relative to those in other countries. It is true that the price of oil has increased and this gives Britain an advantage relative to oil importers. But the futures markets suggest that only half of the increase of 20 per cent since the summer is expected to last to the end of the year. Nor is it very likely that there have been other changes in supply conditions which would justify the sharp rise in sterling that we have seen.
Effects of the Rise in Sterling
We identify three main effects of the appreciation of sterling. First of all, a rising exchange rate means that the prices of goods sold in Britain tend to fall, if those prices are fixed in world rather than UK markets. The range of goods affected in this way may well be wider than Britain's imports. For example the sterling price of oil produced in the UK is reduced by a high exchange rate. This effect, of a rising exchange rate reducing inflation lasts only while the exchange rate is rising. It is sometimes argued that this consequence should be ignored because it relates to a rising rather than a high exchange rate.
There are a number of implications of the argument that such an effect should be ignored. First of all, the argument is presumably symmetric. If the downward pressure on inflation from a rising exchange rate is ignored, so too should be the upward pressure from a falling exchange rate. This leads to the second, more substantial point that, if the impact of exchange rate changes and presumably that of other import price movements is to be ignored, the implication is plainly that the inflation target should be defined in terms of domestic costs rather than the price of consumption goods. In other words, there should be a target for the GDP deflator and not a target for the retail price index. The logic extends to removing the effects of indirect tax changes from the target, so that it should be in terms of the GDP factor cost deflator. There is a great deal to be said for this. The current rise in the exchange rate presents an opportunity to change the target variable without the risk that any political motive will be identified.
A second consequence of the rise is its impact on Britain's real national income. Real national income is calculated by dividing the value of the national product by the price of consumption goods and represents the present and future consumption possibilities available from the nation's income. …