Who's afraid of high exchange rates?

Can we now stop worrying about the exchange rate? For more than five years, economic commentators have been telling us two things. First, the exchange rate is dangerously high; second, it will soon fall. Some add a third comment: when it does fall, we shall be in serious trouble. I shall come to the inconsistency between the first and third points later, but let's examine the first two.

One thing is clear; those who told us the exchange rate was about to fall have been quite wrong. Although the deutschmark disappeared in effect on 1 January 1999 and absolutely on 1 January 2002, it's easier to pretend it is still there so that we can tell a story that starts 10 years or so ago. The UK joined the exchange rate mechanism in October 1990 at a central rate of DM 2.95. We were supposed to stay within a range of plus or minus 6 per cent of that central rate. As some of us remember only too well, we were unable to stay within that range and left the ERM on 16 September 1992, less than two years later.

The conventional wisdom is that we joined at too high a rate and the experience after we left seems to bear that out. The rate fell below DM 2.50, and exports started to grow rapidly. By 1994 we were enjoying rapid GDP growth. But in 1996 the pound started to recover. By 1998 the rate was back above DM 2.90. It moved above DM 3 in 1999 and has stayed there ever since. It is currently above DM 3.10.

Despite all the forecasts, the pound has stayed obstinately high. It has fallen against the dollar; but has remained stable against the so-called trade-weighted index.

Those who got it wrong included the Bank of England's Monetary Policy Committee (and I count myself among the guilty men). As the minutes of the meetings and the quarterly Inflation Reports show, the MPC was baffled by the exchange rate. In the early days it used the market's expectations of the future rate (which always had it falling) and added the risk that it might fall further. That error provides part of the explanation for its tendency to be too pessimistic about the future path of inflation.

One can go back even further to the days of the 'Ken and Eddie show' and suggest that Kenneth Clarke was right in defying the Governor's advice to raise interest rates, since he guessed correctly that the exchange rate might not fall. The MPC has changed its view more recently and uses an average between the market's forecast and an assumption that the rate will not change.

So much for the forecasts. Has the exchange rate been dangerously high? That depends on who you are. It certainly doesn't seem to have harmed the economy as a whole. Recently we have been hit by the severe world recession, but we have weathered it far better than the US or continental Europe. Apart from that, the economy has grown steadily, unemployment has continued to fall and inflation has been at or below its target. Despite the rise in the exchange rate, we have had five very good years.

Or perhaps it isn't 'despite'. Perhaps the rise in the exchange rate has been a by-product of our ability to grow more rapidly than the rest of Europe. And the rise has helped hold down inflation.

But, of course, some parts of the economy have suffered grievously. When I was a member of the Monetary Policy Committee I used to enjoy travelling around the country visiting factories and trying to explain what we were trying to do. I did not so much enjoy the anger from those who were finding it impossible to sell their products into European markets. There were cases where considerable funds had been invested in production lines which would have been profitable had the exchange rate stayed at DM 2.50 or below but which stood idle at a rate above DM 2.90. No one was impressed by my stressing that there was nothing the MPC could do about it.

So, exports in general suffered, and exports of manufactured goods suffered particularly. But as Robert Barrie of Credit Suisse First Boston has argued, it is not clear how large a part the exchange rate played in all of this. The main rise in the rate was against the euro currencies; but the largest deteriora tion in our trade balance was outside Europe. The worsening of our trade balance with Europe was, if anything, surprisingly small, given our faster economic growth.

And now there seem to be brighter prospects ahead. Manufacturing output fell again in March, but business optimism is back to levels last seen before the exchange rate started to rise.

How about the view that it is all going to end in tears when the exchange rate falls? The MPC spends a great deal of time discussing this problem, and it is clear that some members are very nervous about the consequences of a fall in the rate. If we go back to the meeting of February, the minutes record, in unusually sharp terms, a disagreement between those who wanted to leave the interest rate unchanged and those who wanted to cut it.

The hawks (to use the vulgar expression) were worried about the exchange rate falling and causing inflation to rise. They linked this to the imbalance in the economy between strong domestic demand, associated particularly with consumer spending, and weak foreign demand.

But the doves would have none of it: 'The upside risk to inflation from a possible sterling depreciation ... was not relevant to the immediate policy decision. The risks to sterling might not even be on the downside and the associated inflationary implications had almost certainly been overestimated. Moreover, if sterling did fall, there would be time to assess and react to the potential medium-term inflationary implications.'

So there. Those who were against a cut used the risk of a fall in sterling - with an associated rise in inflation - as one of the reasons for leaving rates unchanged. Others disagreed.

Who is right? Of course no one has the slightest idea whether sterling is going to rise, fall or stay the same over the next two years. But one part of the argument used by the hawks seems puzzling. According to the minutes they say: 'There was evidence that the exchange rate was overvalued'. I have already suggested that the evidence is far from overwhelming. However, let us suppose that they are right. Any problem would relate to the real value of the exchange rate - taking into account both the nominal exchange rate and relative prices and costs here and in the rest of the world. If the real rate is unsustainable, the easiest way in which adjustment can come about is through a fall in the nominal exchange rate.

That may happen at some stage - ideally at the same time as domestic demand slowed down so that demand would shift from domestic to foreign markets. But that would have no direct implication for UK inflation, so what are they, as hawks, worried about?

There would be a challenge to the MPC if the rate were to fall while we still had a consumer boom. But we all know what they should do then. Meanwhile they, like the rest of us, should stop worrying about the exchange rate.

Alan Budd is Provost of the Queen's College, Oxford and a former member of the Monetary Policy Committee

William Keegan is on sabbatical