The Pound and the Punt: A Study in Exchange Rate Policy

The rise in sterling during 1979 and 1980 was a remarkable and largely unexpected development While it has been accepted that the rise in the exchange rate played an important part in the reduction in the UK inflation rate during 1980 it has also been suggested that the appreciation of sterling was a major cause of the fall in output, particularly in the manufacturing sector.
In this Viewpoint we attempt to assess the effect of the rise in sterling on output and inflation by comparing the performance of the UK economy with that of the Irish Republic. As a member of the European Monetary System (EMS), Ireland shared the general depreciation of the European currencies against sterling. We suggest that the result has been a higher rate of inflation in Ireland than in the UK Also, although the Irish manufacturing sector avoided the UK's loss of competitiveness, the fall in manufacturing output in Ireland during 1980 was - when allowance is made for a higher underlying rate of growth in Ireland - comparable to that in the UK     

WORLD OUTLOOK

In the course of 1984 growth rates in the major economies came together. This reflects a slowdown in the United States, and to a lesser extent Japan, from the middle of the year and continuing recovery in Europe. This convergence is expected to continue in 1985 when total output in the OECD area is forecast to increase by 3 per cent. Within this total it is likely that the US, West Germany and the UK all achieve about 3 per cent; Japan should grow more quickly, France more slowly. In spite of a rapid recovery in output from the late-1982 trough, inflationary pressures remain weak. Measured in dollar terms, non-oil commodity prices have fallen and the oil price is under considerable down wards pressure. We expect inflation to stay at about its preset level in the US, West Germany, Japan and the UK and decline further in France, Italy and other countries where policy reaction to the 1979-80 oil price shock was delayed. In the medium term we expect the world economy to experience steady growth combined with a constant or slightly increasing inflation rate. This reflects a stable policy environment and falling real oil prices. After the excesses of the 1970s and early 1980s it is possible that the rest of the decade will experience u greater stability than at any time since the 1960s.     

Monetary Targets and the World Economy

The dominant obsessions to watchers of the world economy at the moment are the weakness of the US dollar and the fear that the world economy is stagnating. In this ‘Briefing Paper’ we seek to put both events into the same intellectual framework, and to show that they are the consequence of monetary policies which are not logically related to each other, nor to a common objective of bringing world inflation steadily down to an acceptable level. Specifically, the US - which for reasons outlined below can warrant monetary growth rather below the world average if it is to preserve some dollar stability - is showing an above average outturn in its monetary aggregates. Germany and Japan, which can accommodate increases well above the average, are in fact adopting monetary targets which are leading to exchange rate appreciation, arid a reduction in both countries' expectations for real growth. The dangers for the world economy in this situation are very serious, particularly at a time when further dollar devaluation could be risky both from the viewpoint of US inflation wide the dollar's role as the key reserve asset. It could lead at worst to US protectionism and a monetaryled recession, rein forcing the slow growth rates already being widely predicted in 1978 for many other industrial countries. However, we show in this ‘Briefing Paper’ that this is not a necessity outcome of the present situation, given three vital perceptions. The first, required by statesmen as much as by technicians. is that the recent stagnation in European & Japanese output and exchange rate instability are essentially a monetary phenomenon, requiring essentially monetary (rather than fiscal) remedies. The second is acceptance of the need and practicability of some monetary consignation, based on reasonably common objectives among the major countries regarding inflation, bands for exchange rate movement and red rates of growth. the third, at the most practical level, is agreement on the actual monetary numbers which broadly reconcile these objectives and also take account of the very different ‘unwanted’ rates of monetary growth between countries which reflect their different underlying conditions of output, productivity and demand for money. It is the (ambitious) aim of this ‘Briefing Paper’ to substantiate these perceptions and to provide the numbers mound which a consideration of monetary policies can be framed. The numbers are necessarily based on trends established over a number of years and need to be supplemented by detailed understanding of each country's financial status But the monetary targets provided do, in our judgement, embody trade-offs between inflation, growth and exchange rate movements which should broadly satisfy national ambitions, and reset the world economy on a worthwhile growth path during 1978 or 1979.     

WORLD OUTLOOK

The strength of US domestic demand is exerting a very strong pull on the world economy. Japan in particular is benefiting from soaring export demand, but the effects on European exports have been offset by weak domestic demand and, in the case of West Germany and the UK, by damaging industrial disputes which have interrupted supply. Over the next 12 months we expect the US economy to slow down under the weight of the financial and external balance pressures, which two years of very rapid but unbalanced growth have built up. For the world economy, however, we expect the slowdown in the US to be counterbalanced by expanding domestic demand in Europe and Japan, especially if a lower dollar permits reductions in interest rates. We forecast world output growth of about 3 per cent next year, well below the near-5 per cent projected for 1984 - the cyclical peak. By the second half of 1985 the world recovery will be three years old and we expect a pause in the growth of output. Against a background of stable monetary growth we expect world inflation in the 5–6 per cent range over the medium term. This is consistent with some increase in US inflation, low and stable inflation in Japan and West Germany and further progress in reducing inflation in countries such as France and Italy. Our forecast is based on the assumption that the dollar falls next year. If it does not fail we believe there is a significant risk of slower growth.     

The London Business School with Gower Publishing

The world economy is just starting to emerge from the second trough of a "W-shaped" recession. Compared with the experience after the first oil shock, when industrial production fell by 12 per cent, bringing inflation quickly down from 14 per cent into single figures. the 1980 world recession was mild. Between the first and third quarters industrial output fell 5 per cent; it recovered in the fourth quarter and inflation stopped falling. As a result governments - and this is especially true of the United States - look "another bite at the cherry": monetary policy was tightened and interest rates rose. The effect over the last six months has been to produce a second dip in output. The renewed attack on inflation has, however, been successful and inflation is now well in single figures and falling. Consequently a general easing of policy is evident and a recovery of output in the second half of 1982 and into 1983 remains our forecast.     

Towards Exchange Rate Stability?

At their recent meeting in Washington the Group of Seven reafirmed their desire to hold exchange rates at about their current level. In this Viewpoint we consider the prospects for success. We conclude that although current rates are feasible in terms of competitiveness, the system will remain under strain as long as there are major inconsistencies between jiscal policy in the US and the rest of the world. The present conjuncture of interest rates and inflation points to a further dollar depreciation. It would be better, in our view, to enact this quickly and to attempt to stabilize exchange rates at sustainable levels: the policy of holding the dollar is misguided.     

Economic Viewpoint: Towards Exchange Rate Stability?

At their recent meeting in Washington the Group of Seven reafirmed their desire to hold exchange rates at about their current level. In this Viewpoint we consider the prospects for success. We conclude that although current rates are feasible in terms of competitiveness, the system will remain under strain as long as there are major inconsistencies between jiscal policy in the US and the rest of the world. The present conjuncture of interest rates and inflation points to a further dollar depreciation. It would be better, in our view, to enact this quickly and to attempt to stabilize exchange rates at sustainable levels: the policy of holding the dollar is misguided.     

Forecast Summary

Nearly two years after the I990peak in output, the economy continues to 'bump along the bottom' of an L-shaped recession, which has turned into as severe a downturn as its predecessors in 1974-5 and 1980-1. The origins of the recession lie in the weakness of domestic demand, which has failed to respond to the 4.5per cent cut in interest rates that has taken place since we joined the ERM. It is now the turn of fiscalpolicy: public spending was raised in the Autumn Statement and, as the General Election approaches, the odds are on tax cuts in next month's Budget. This relaxation of monetary and fiscal policy should produce recovery and we see output moving ahead from the second quarter onwards. Nevertheless, the outlook for I992 is weaker than before: we forecast a rise in GDP of a little over I per cent, rather less for manufacturing industry. In 1993 and beyond n growth rate of around 2112per cent should be possible but it is the second half of next year before output passes its previous peak. This suggests that unemployment will rise for at least another year - to a peak in the summer of I993 of 2.8 million. The combination of a stable exchange rate inside the ERM and protracted recession has produced a rapid reduction in inflation and the current account deficit. As long as the pound maintains its present parity, inflation should moderate further, to the 3–4 per cent range by the end of the year and beyond. On the trade side, in contrast, imports have already bottomed out and exports are struggling in a weak world economy. This suggests that, as the recovery gets under way, the deficit on current account will widen from last year's £6bn to £8bn this year and £10bn by I995.     

The Dollar, the Oil Price and Policy Divergence

There is currently a clear divergence of policy between the United States, Japan and Germany. With the US in recession and concern growing over the severity of the slump, interest rates have been cut in a move to revive the economy. In contrast Japan and Germany are both experiencing strong growth and monetary policy remains tight to combat inflation. This divergence was seen most clearly when the Federal Reserve Board lowered its discount rate to 6 per cent on 1 February, the day after the Bundesbank had raised its Lombard rate to 9 per cent. With G7 increasingly concerned about domestic factors, less emphasis is placed upon stable exchange rates and as a result the dollar is at an all-time low. The last two G7 communiqués have stressed ‘stability oriented monetary policies’, an ambiguous phrase which fails to define ‘stability’ either in terms of exchange rates, inflation or growth. Thus both the German and Japanese policy of high interest rates to reduce inflation and low US interest rates aimed at stimulating the economy can be termed as ‘stability oriented’. This analysis focuses on these divergent policy responses in two alternative scenarios to the world forecast we presented last month. The first scenario considers what might happen if the Federal Reserve Board were to stimulate the US economy by further cuts in interest rates, whilst Japanese and German rates were unchanged in the face of inflationary pressures. This case may be relevant if the recent US loosening of monetary policy is not sufficient to encourage growth because of a ‘credit crunch’, so that a more expansionary policy is required by the Fed. As a consequence, policy diverges further and the dollar weakens. The second scenario focuses upon a reduction in inflationary pressures in Japan and Germany brought about by an oil price fall. In this case we assume that US policy is already loose enough to avoid a prolonged recession, but that German and Japanese monetary policy is relaxed as inflationary forces recede. In this case policies converge. Each scenario thus concentrates on one of !he two features which are causing the policy divergence amongst G3 countries: recession in the US, inflation in Germany and Japan.     

The Medium Term Outlook

The prospects are that the next four years will be considerably worse than the last four; the contrast between 1980/81 and 1978/79 is even more stark. Faced with the prospects of a world recession and a government whose main policy objective is to bring down the rate of inflation, UK output is expected to be the major casualty. Only North Sea oil     

WORLD OUTLOOK

At the end of 1982 output in the world economy was still falling, although there were signs that the decline had very nearly run its course. We expect a radual recovery to begin in the first half o f 1983. Unlike the recovery which began in the late summer of 1980, when inflation was still in double figures, any upturn in 1983 would be set against a background of declining inflationary expectations and weak oil prices. IJ. as we expect, a falling inflation rate proves a decisive factor in keeping interest rates on a downward path, we forecast that the output will gather pace in I983 and rise reasonably strongly in 1984. Of the 4 per cent rise in industrial production which we foresee in 1984. a large part is due to the fall in real oil prices.     

WORLD OUTLOOK

Unless the international debt situation or the crisis in the US domestic financial system worsens or there is a further lurch into protectionism, we expect world output to advance more rapidly over the next 2 months than it has over the last year. We argued in May that the world recovery was pausing, just as it did in 1977, and that conditions were falling into place for a pick-up in output. The requirements were seen as a lower dollar, to improve US competitiveness and to alleviate protectionist pressures, and stronger domestic demand elsewhere, to offset the resulting loss of US markets. Since then the case for a lower dollar has been recognised by the Group of Five Finance Ministers, interest rates have fallen and, at the G5 meeting, West Germany and Japan tentatively revealed a further modest stimulus. Output optimism is underpinned by the fall in world inflation to levels not seen since the early 1970s which, our forecast suggests, will be consolidated over the next 12 months. This reflects falling real oil and non-oil Commodity prices and decelerating earnings, which makes a further tightening of policy unlikely. In these circumstances the prospects for output are improving and over the next 12 months we forecast an increase in OECD output of 4per cent.     

Productivity and Inflation: a Paradox

In his Budget speech, Mr. Lawson drew attention to the greatly improved record of productivity growth in UK manufacturing:
"During the 1960s, and again in the 1970s, growth in manufacturing productivity in the UK was the lowest of all the seven major industrial countries in the world. During the 1980s, our annual rate of growth of output per head in manufacturing has been the highest of all the seven major industrial countries."
Ironically this success in regard to productivity may cause a problem in regard to inflation if the UK moves to a fixed exchange rate policy within the EMS. In this Viewpoint we report the consequence of such a move and also describe the possible required rise in the exchange rate if price stability is to be attained. We show that price stability requires the exchange rate to rise (i) to offset world inflation and (ii) to compensate for the productivity gap between the traded and non-traded sectors.     

WORLD OUTLOOK

The world recovery, now three years old, has proved more resilient than many expected and will be sustained in 1986 by lower oil prices. Fears that the early-1985 slowdown would turn into renewed recession have proved unfounded, as output in both the United States and Europe picked up in the second half of the year. The improvement stemmed from lower interest rates, falling inflation and weak commodity prices and was further helped by the sharp correction to the value of the dollar following September's G5 agreement. To these factors, which will remain supportive this year, is now added a lower oil price. The recovery in world output has not produced an increase in oil demand and, as the oil price rise of 1979-80 gave a further boost to supply from non-OPEC sources, a severe imbalance has emerged in the oil market. To maintain a £26 marker price (itself cut from £29 last July) has required a cutback in production of ever-increasing magnitude from Saudi Arabia in its role as OPEC's swing producer. Now that Saudi Arabia has abandoned this role in favour of stabilising its market share, oil prices have fallen sharply. We assume that the oil price will fall to £20 by the end of this year, a fall in real terms of 30 per cent. As a result the world recovery is given renewed impetus and output accelerates over the next twelve months. A cyclical peak in activity emerges in 1987, after which output growth settles at 2%-3 per cent and inflation at 4–5 per cent.     

Some empirical evidence on the real effects of nominal volatility

It has been argued that volatility in nominal macroeconomic aggregates has had a negative effect on real output, in particular that such volatility contributed to slow output growth in the early 1980s. This paper reexamines the effects of volatility in nominal macroeconomic aggregates in the context of a modern simultaneous equation framework where the volatility of, nominal macroeconomic variables is modeled as the conditional variance of two variables of interest: the federal funds rate and inflation. The empirical framework is the recently developed multivariate GARCH-in-mean vector autoregressive model. We confirm evidence that inflation volatility and tight monetary policy have directly affected output growth, but find that volatility in the federal funds rate has not.     

Forecast Summary

The economy has entered a growth recession but we do not expect an absolute decline in output. Consumer spending has belatedly responded to higher interest rates but the key to the short-term outlook is the company sector whose financial position has deteriorated sharply. The response is likely to be a pause in the growth of investment and large-scale destocking - reminiscent of 1980-1. But the contrast with the early 1980s' recession is as important as the similarity: it is the "sheltered" sector which will bear the brunt of the demand slowdown. Exports and thus manufacturing industry will be boosted by a competitive exchange rate, and this will provide a significant, though one-off, improvement to the current account. The lower pound, actual and prospective, will hinder any reduction in inflation and it is not until 1992 that retail price inflation falls below 5 per cent.     

Forecast Summary

As the Chancellor recognised in his Mansion House speech, sterling M3 is once again proving to be a wayward indicator, and it is the exchange rate which is currently the principal instrument of the government's policy to reduce inflation. The strength of sterling, reinforced by the Group of Five commitment to a lower dollar, is the main factor behind decelerating retail prices and we endorse the Chancellor's forecast that inflation will fall to under 4 per cent in the middle of next year. A strong exchange rate, however, hits UK competitiveness and results in a slower rate of growth in output next year. Output growth, over 3% per cent this year including the post-strike rebound, remains at 2% per cent in 1986 and comes down to an underlying 2 per cent in the medium term.     

The London Business School Gower Publishing

The 1989/90 payround is under way against the background of the highest rate of inflation in nearly seven years, the lowest rate of unemployment since December 1980 and a spate of industrial disputes which feature pay as a central theme. Reflecting this, pay settlements are moving higher and whole economy earnings are rising at an underlying rate of 9.25per cent, compared with only 7.5 per cent in early 1987. The obvious danger, with the labour market remaining tight, is that earnings will accelerate further, possibly into double figures. If this were to coincide with slower output growth, unit labour cost inflation would increase sharply, either threatening the government's inflation objectives or, as in 1980–81, resulting in a squeeze on profits - a hard landing. In our June forecast, we ruled out this possibility - at least as the central case - but at the same time we warned that "the main economic danger lies in this area: if wage bargainers are successful in bidding up wages to compensate for higher retail price inflation, the battle to reduce inflation could be even more protracted than our forecast suggests and output prospects too would be that much weaker". In this Forecast Release we return to this theme.     

Does trade integration alter monetary policy transmission?

This paper explores the role of trade integration—or openness—for monetary policy transmission in a medium-scale new Keynesian model. Allowing for strategic complementarities in price setting, we highlight a new dimension of the exchange rate channel by which monetary policy directly impacts domestic inflation: a monetary contraction which appreciates the exchange rate lowers the local currency price of imported goods; this, in turn, induces domestic producers to lower their prices too. We pin down key parameters of the model by matching impulse responses obtained from a vector autoregression on time series for the US relative to the euro area. Our estimation procedure yields plausible parameter values and suggests a strong role for strategic complementarities. Counterfactual simulations show that openness alters monetary transmission significantly. While the contractionary effect of a monetary policy shock on inflation and output tends to increase in openness, we find that monetary policy's control over inflation increases, as the output decline which is necessary to bring about a given reduction of inflation is smaller in more open economies.     

Briefing Paper: The Interdependence of Fiscal and Monetary Policy under Economic and Monetary Union

This article explores the implications of Economic and Monetary Union (EMU) for the conduct of fiscal policy. Under EMU, where the European Central Bank is successful in controlling inflation, the loss of seigniorage revenues causes a potential problem for public sector deficits. To prevent the debt-income ratio from spiralling upwards, a primary budget surplus is ultimately required. EMU has usually been considered as a strong central monetary authority which forces fiscal discipline on lax national governments. But this is not the only possibility. Because the debt ratio can be reduced by surprise inflation, the price expectations of the private sector are important. Once these are taken into account, EMU can be examined in a 'game' framework in which the reputation of the authorities and the existence or otherwise of cooperation between the fiscal and monetary authorities becomes a critical factor.
The paper finds that where the authorities enjoy reputation and cooperate, a one-off reduction in public spending will lead to a permanent decline in the real interest rate and crowd in extra private spending (consumption and investment). Without reputation the cut in government spending has to be sustained. Where there is neither reputation nor cooperation, the outcome depends on the structure of the European economy and whether fiscal policy can effect the terms of trade between countries. If the terms of trade remain unchanged, the outturn is similar to the case of cooperation without reputation, but where the terms of trade can be improved in one country, there is no incentive to cut public spending. In this case the outturn is higher inflation with private spending crowded out.