Brown's studies: exchange rates

Sterling fell on the foreign exchanges yesterday after the Treasury said the right level for the pound to join the single currency would be slightly lower than it is today.

After the hefty devaluation in sterling over the past year, an analysis by Simon Wren-Lewis of Exeter University suggested that the pound was close to a level at which Britain could live with membership of the euro.

Professor Wren-Lewis's work found that the equilibrium exchange rate for sterling was €1.37 to the pound, compared with the €1.42 level at the close of business last Friday.

After the release of the study as part of the Treasury's 18 background documents, sterling lost ground against the euro, falling to around €1.41.

Prof Wren-Lewis said alternative methods for calculating the exchange rate for EMU entry suggested a lower level of between €1.175 and €1.33 to the pound, although this had been overtaken by recent economic trends.

A separate study by Peter Westaway of the Bank of England underlines the importance of choosing the right entry rate for sterling if the transition to monetary union is to be smooth.

Pointing out that inflation in Britain would have been higher and growth lower had sterling joined the single currency in the first wave in 1999, Mr Westaway said too high an exchange rate could lead to deflation, while too low an exchange rate could cause inflation.

He concludes: "If there were complete cyclical convergence between the UK and euro area, if the real exchange rate were at its equilibrium level, and if target inflation were the same inside or outside EMU, then the transition to EMU would be costless. Neither inflation nor output would need to adjust as a direct consequence of locking the nominal exchange rate."

But the study warns of the costs of getting the exchange rate wrong. If the entry level were weaker than the long-run equilibrium, then "the transition path would be likely to imply higher inflation and greater output volatility... This could be partly moderated by having either tighter monetary policy during the pre-entry period or a significant fiscal tightening over the transition. But for all such cases, the analysis points to outcomes that would be considerably worse than either the option of staying out or of joining EMU at prevailing rates."

Alternatively, too strong an exchange rate would lead to deflationary pressure. With devaluation ruled out, the UK could only reduce its real (inflation-adjusted) exchange rate by having lower inflation than the rest of the eurozone.

"And to achieve this, given that wages and prices are typically slow to adjust, this would require a period where UK output would need to operate below potential," the study says.

"This would need to be sustained for as long as would be necessary to bring down the UK price level to levels consistent with the lower required real exchange rate."