The foreign exchange markets are posing tricky problems for the Government and the Central Bank. In its management of the exchange rate, under policy set by the Government, the bank is trying to achieve two goals. One is to bear down on inflation by having a strong exchange rate thus holding down importprices. The other is to try to maintain a stable value for the pound against the currencies of the other members of the Exchange Rate Mechanism, which along with the pound are the likely founder members of the new EU single currency. The latest surge of sterling on the markets, if it continues, means that both goals cannot be achieved simultaneously.
The problem faced by the Central Bank is clear. If it allows the pound to fall rapidly against a rising sterling, then it risks fuelling inflation through higher import prices. But supporting the pound against sterling by stepping into the market and buying the Irish currency pushes it up against the ERM currencies, such as the deutschmark. This will be unwelcome to the Central Bank, as it means a volatile exchange rate against the other ERM currencies.
The Central Bank's interventions in the currency markets in recent days suggest that its priority is controlling inflation by not allowing the pound to slip too far in value against sterling. The precise relationship between the pound/sterling exchange rate and Irish inflation is not clear. Some analysts argue that what matters is the average value of the pound against all our trading partners, and not just sterling.
However, given the level of consumer imports from Britain, the bank's caution in trying to support the pound against the British currency appears to be the correct course of action. Controlling inflation late this year and moving into 1997 is all the more important because next year's rate will count towards qualification for the single currency.
The bank - and the Government - will now hope that sterling will settle down in value on the markets. This may happen, but equally the British currency could rise further. This would heighten the dilemma. There appears no risk that the pound will break out of the 15 per cent ERM band against the other EU currencies. But if the pound rises much further against currencies such as the deutschmark, then investors will increasingly question its suitability for inclusion as a founder member of the single currency. Other EU governments, who now count Ireland as a likely founder member, may also sit up and take notice.
The latest moves on the market also highlight the importance of planning for the advent of a single currency. For if the pound is a founder member and sterling is not, then this economy will be affected by sterling's swings. So far most attention has been paid to the threat of a depreciation in sterling and the impact this would have on industrial competitiveness. But the recent rise of the British currency highlights the inflationary threat which sterling's strength could pose.
The key message is that economic management will, in some cases, become more problematic in a monetary union, with no possibility of adjustment in the pound's exchange rate. This will place a premium on achieving greater flexibility in all areas of the economy and on improving competitiveness. Both of these considerations must be central to striking a new national agreement to replace the Programme for Competitiveness and Work.