Lower value for pound in ERM now central to policy

A LOWER value for the pound within the EU exchange rate mechanism is becoming a major policy priority of the Department of Finance. The Government sets exchange rate policy and the Department is believed to have made it clear to the Central Bank that our exchange rate policy is now to be dictated by the deutschmark and other core European currencies.

Until a few weeks ago, both the Department and the Central Bank were attempting to get the pound to track the trade weighted index, an average of the currency values of our trading partners. However, three sets of inflation data which have come in well below expectations have eased the authorities' fears about the inflationary danger of a weak pound against sterling.

According to the ESRI and others the major determinant of Irish inflation in recent years has been British inflation and the sterling exchange rate. This theory suggests we should already have seen some evidence of a pick-up in the retail prices index. Clearly there are other factors at work.

One explanation is that competition, particularly in the retail sector, is holding price increases back. If this is true, then it is not something that will, last in the long-term. It could be argued that low inflation is one of the benefits of the single market. After all, it is because of the single market that the British multiples are coming in.

Such arguments mean the authorities are reasonably sanguine about the pound falling against sterling, at least in the short-term. However, actually achieving a decline in the value of the pound against the deutschmark or French franc would be no easy task. A soaring sterling has traditionally dragged the pound up on its heels. And Central Bank interventions cannot necessarily force a change of direction.

The authorities are hoping that the markets will do much of the work for them. So far, the Central Bank has not been involved in very significant interventions and yet the pound has decoupled from sterling.

Until a month or so ago, the pound tracked sterling higher against the deutschmark, albeit several pfennigs below. But it now is around 20 pfennigs lower than sterling. One reason is that the pound found it very hard to go though our old pre-devaluation central rate of 2.67 deutschmarks.

But keeping a lid on our rises in the ERM is one thing, actually driving the pound back down towards the central rate is another. The Government and the Central Bank are fervently hoping that sterling would start to fall in value before too long.

They hope that the pound would be trading as close as possible to 2.41 deutschmarks - its central ERM rate - when the announcement is made next April about which countries would be participating in monetary union. This is because it now looks as if the central rates in the ERM would be the choice for conversion to the euro, because they are seen as fair and all EU governments have already agreed on them. It is also likely that the decision to use the central rates will be announced before the actual conversion to the euro on January 1st, 1999 - possibly as early as next summer.

This means it is imperative that the authorities begin to push the currency in that direction, as well as massaging interest rates down

When the announcement is made the exchange rate is likely to hit 2.41 practically immediately and forward interest rates will fall to central EU levels. The Government and the Central Bank thus hope that when the announcement is made, the pound will be close to the rate at which it would join the single currency and interest rates would be close to continental EU levels. Otherwise destabilising trading in the markets would be in prospect.

However, the Bank is likely to at least wait until August or September before cutting rates to check that inflation has not been picking up because of the low rate against sterling. If the market then believes that the project is to go ahead, money would flood into the bond market, pushing rates down whether the Bank liked it or not.

Of course, if sterling were to weaken, then the whole job would be made that much easier. But currency forecasting is a notoriously difficult business.