Currency dilemma leaves Bank with EMU headache

THE Central Bank is engaged in "Mission Impossible" in the currency markets. In an ideal world it would like to see the pound trade firmly against sterling, while staying close to our prospective monetary union partners in the ERM band. At the moment both these goals are proving impossible, as the pound is pulled up against the other ERM currencies in tandem with a rampant sterling, while at the same time losing ground against the British currency.

Our control over the pound is, of course, due to self destruct in less than two years time, when monetary union commences. In the meantime things are not shaping up very well. The current trends in the market, if they continue, will create a major headache for the Central Bank. And they also highlight some of the difficulties which will face policy makers inside monetary union.

For the moment, there is no stopping sterling. The British currency is leaping ahead, with investors encouraged by the prospect of higher interest rates and an improving economic performance. And most forecasters believe that sterling is heading yet higher. The Bank will be keeping its fingers crossed and hoping that something will come along to unsettle investor sentiment in the British currency.

Next week, for example, the Chancellor of the Exchequer and the governor of the Bank of England are due to meet and a failure to raise interest rates could hit sterling.

But yesterday it was the same old story in the markets. A rising sterling pulled the pound up in its wake. The Irish currency is still easing back against the British unit, but gaining substantially in the ERM band. Something of a landmark was reached yesterday when the pound returned to its pre January 1993 devaluation level against the deutschmark.

Now the worry is that we could climb even higher. When the new ERM bands were created in summer after the currency crisis, finance ministers agreed to allow currencies to vary by 15 per cent in value up or down against any other currency. At the time it was thought that this, would effectively allow freely floating currencies. But with the pound now 9.4 per cent above the French franc, it is not beyond the bounds of possibility that a rising pound and a falling French franc could combine to leave the two currencies close to IS per cent apart.

The problem for the Government and the Central Bank is that the pound's movements in the ERM leave it far detached from the other currencies with which we hope to form a monetary union.

This is unlikely to be in breach of the Maastricht rules. They state that currencies joining monetary union must have traded within the normal margins of the ERM for the previous two years. When the rules were drawn up it was envisaged that the "normal band" would be the old 2.25 per cent band. But now the 15 per cent band is the only one in existence and so Ireland could hardly be excluded.

However, the other prospective members of monetary union are all trading roughly within the width of the old narrow band and the position of the pound is an uncomfortable one, particularly as it highlights the traditional link with sterling.

The strength of the currency in the ERM may also affect interest rate policy. NCB stockbrokers argued in a recent note that the only way an interest rate move would slow credit growth would be if it was a sizeable increase of around one percentage point. However, such a move is unlikely, as it would send the pound yet higher in the ERM.

All in all the Bank's hands are tied and it will be fervently hoping for a relapse in sterling's health.

Policy makers might consider that if the pound was a member of a monetary union formed earlier this year, our rate against sterling would be in the low 90ps, which would have major implications for the control of inflation. The Central Bank has few enough policy options now after monetary union it will have none at all.