Central Bank forced into a delicate balancing act

IT is the destiny of central bankers to be unloved. They stand, spectres at the feast, always ready to end the party early and send everyone home. Although there are more savers than borrowers in the economy, a rate cut is met with delight and seen as grudgingly conceded by central bankers, whereas a rate rise is met with dismay by the media and public alike.

Take the current economic scene in Ireland: the economy is clearly booming, employment growth is strong, inflation is only 1.5 per cent and the Central Bank sought and secured higher mortgage rates, and is currently intervening to prevent rates falling back down.

Yet one has to feel some sympathy for our guardians of the currency in Dame Street, as not only are they seeking to ensure Irish inflation remains low enough for EMU qualification, but they are hampered by the simultaneous need to keep the currency from appreciating. To make matters worse, the foreign exchange rate constraint emanates from Merrion Street, not Dame Street. But something has to give the currency has to rise, or rates must stay high, at least for the next six months or more.

To understand how this situation arose, it is worth noting that the Bank is responsible for implementing monetary policy, whereas the Minister for Finance determines the appropriate exchange rate.

This split in responsibilities throws up the possibility of a potential conflict of interest, and it would appear an example has arisen in the last few weeks to keep Irish inflation low, the currency needs to appreciate, but the Central Bank have been selling the pound, apparently to prevent an appreciation of the green pound which would trigger a fall in agricultural incomes.

Moreover, there may be a further agenda at play, namely the need to keep the pound within tight bands against the German mark. Whatever the reasons, the pound has fallen by two pence against sterling in the last month which, if it persists, will threaten to reverse the key factor in Ireland's economic miracle a booming economy with little or no inflation.

For most of the last decade, governments' foreign exchange requirements sat easily with the Central Bank's interest rate policy, because the pound was locked into a very tight band against the German mark. The D mark was the anti inflation anchor, so rates moved up and down in tandem with the pound/D mark: rates would only rise if the pound fell against the D mark and rates would fall if the pound was comfortable against the D mark.

Since the move to wider ERM bands (15 per cent since August, 1993), the picture becomes cloudier. The pound fell sharply against the D mark in 1995, but the Central Bank sold the pound aggressively for most of the year, presumably because the Government was unhappy at the pound's appreciation to 103 pence against sterling, which was endangering Irish competitiveness in Britain. However, it also kept inflation low, as more than one third of our imports are from Britain.

However, policy appeared to change again in early 1996, as the EMU train gathered speed. If monetary union happens in 1999, currencies have to be linked together at a particular exchange rate, and it is probable that European governments have decided to use the central rates in the ERM as the appropriate rates. Certainly, it is apparent that all ERM currencies have converged to their central rates in the past few months, including the pound, and that the Central Bank were buyers of the pound in the first half of the year, not sellers as in 1995. A de facto return to the pre 1993 2 per cent bands has occurred.

So this means that if the pound strengthens against the D mark, as it has in the past month, the Central Bank may not allow it to strengthen above say DM2.465, which is the old 2.25 per cent limit against the D mark. Furthermore, the pound's strength in the ERM has threatened to precipitate a revaluation of the green pound (which is the means of payment of agricultural support and subsidies) as the pound is some 5 per cent away from its current green rate, the limit allowed under EU rules.

If the pound's strength persists, the green pound would be revalued by 2.5 per cent to 3 per cent, meaning that all EU payments (made in ECUs) would fall in value in pound terms and add to the woes of the agricultural sector.

So the Bank and the Government face some tough decisions. If the Bank continues to sell the pound it adds cash to the system, thereby pushing money rates down, possibly leading to a mortgage rate cut. Moreover, the fall against sterling directly pushes import prices up and hence eventually seeps into consumer prices generally.

However, if they allow the pound to rise, it will breach the old narrow band against the D mark and trigger a green pound revaluation, so hitting farm incomes.

In the short term, the Bank can attempt to balance the conflicting aims, but if the domestic economy requires a tight monetary policy (which is the case, particularly with a tax cutting budget three months away) the currency must rise, otherwise next year's inflation rate is likely to exceed the current 2-2.25 per cent consensus range. The ultimate irony would be that Ireland failed the EMU criterion on inflation to placate an interest group which is the most pro European sector in the economy.