Since last week's intervention by the central banks, markets have focused almost exclusively on the relationship - both past and prospective - between the euro and the dollar. Important as this is, it remains the case that the critical exchange rate influencing Irish economic prospects is the pound against sterling. What might not be fully appreciated is that the UK is also the European single currency area's most important trading partner, edging the US into second place. As a result, the outlook for sterling is of interest beyond the Irish Sea.
In the past 21 months the UK currency has frequently been buffeted in the rather one-sided crossfire between the dollar and the European "super currency". For this reason any forecast for sterling must first assess whether the sortie undertaken by central banks last week marks a turning point in the euro's fortunes.
My own guess is that it will take more substantial intervention - possibly beginning from a lower level and in more troublesome circumstances than currently prevail - to signal a decisive improvement in the euro. That said, a softer trend in activity in the US, coupled with a relatively high inflation rate and a yawning trade gap could stem the tide of capital flows into the dollar before long. As a result, the euro may begin next year on a less unfavourable footing.
Some months ago this would have implied similar prospects against sterling. However, more recently, sterling has exhibited more "independence". This hints at the increasing importance of domestic UK influences on sterling. These same factors could boost the euro on a 12-month view. First of all, the UK economy seems set for solid but not sizzling growth. Household spending power should remain solid, supported by the lowest jobless rate in 25 years. The looming election will also encourage a generous budget. However, a significant fall in UK house price inflation of late and the sluggishness of retail spending - two important barometers of people's assessment of their own income and wealth prospects - suggest no great expectation of an economic boom.
In addition, British exports will be restrained by a probable easing in global growth and the impact of sterling strength - even if sterling falls sharply now, lost market share will take time to rebuild.
On its own, this growth outlook would not be decisive, but there are also tentative signs that market sentiment is turning more negative on sterling. A key factor is a growing realisation that the Bank of England is extremely concerned about sterling and is now giving the exchange rate much more weight in interest rate policy decisions. It might seem blindingly obvious that the Bank of England would respond to the difficulties facing British manufacturing - but as this sector accounts for little more than 20 per cent of UK activity that response might not be expected to be substantial.
I would argue that the Bank of England has begun to recognise that the UK economy now operates in a fundamentally different way in the shadow of the European single currency. Before EMU, external constraints on British policy-making were less critical. With sterling one of a set of similar or smaller vessels, the UK could hope to chart an independent course. Now dwarfed by the euro "supertanker", sterling's exchange rate has become a critical source of "shocks" to the UK economy. Put another way, EMU has made the UK closer to the small open economy model long seen as representative of Irish economic conditions.
This awareness of the increasing importance of the exchange rate has been greatly amplified by the judgment that sterling is significantly overvalued against the euro.
Sushil Wadhwani, a member of the Bank of England's monetary policy committee, has estimated that sterling's "fair value" could be about 10 per cent below current levels. Such calculations in themselves are not very useful as aids to currency forecasting but to the extent that they influence policy-making they can be important. It is clear that the role played by the exchange rate in Bank of England policy-making has changed. About a year ago, the Bank argued that the prospect of an eventual sterling fall required higher UK interest rates. More recently, it has been suggested that interest rate policy should be less aggressive in such circumstances because higher interest rates could force sterling to higher and less sustainable levels, which, once an inevitable collapse occurred, would precipitate a much larger rise in UK inflation.
Earlier this week, new research undertaken in the Bank of England set out a more formal link between the influence of interest rates and the exchange rate on the UK economy. It suggested that exchange rates have "more protracted effects on output than changes in interest rates". It also concluded that if interest rates and the exchange rate remained around current levels, an effective policy tightening would take place over the next two years.
In brief, if UK policy-making pays more attention to sterling, the risk of sharp volatility in this key influence on Irish economic prospects should be reduced. Furthermore, if the Bank of England is successful in its endeavours, there is a greater likelihood of a modest rise in the Irish pound against sterling in the coming year.
Austin Hughes is chief economist at IIB Bank
