The sharp fall in the value of the pound on the markets yesterday came as a surprise. in recent weeks the Central Bank has been buying pounds to stop the currency from weakening too much in value against sterling. But yesterday the Bank decided to step back and as a result the pound fell sharply, not only against sterling, but also against other currencies such as the deutschmark and the French franc. By late afternoon the situation had stabilised, but the Irish currency still ended the day well below its opening value and the outlook for today and beyond is uncertain.
It might seem surprising that the pound should fall on the day that the latest mediumterm forecast from the Economic and Social Research institute (ESRI) predicted a future of strong growth. However the latest events on the markets are being driven by the planned move to EU monetary union in January 1999.
The selling of the pound on the markets indicates that investors believe that the rate at which it had been trading in the EU exchange rate mechanism is well above the rate at which the currency is likely to enter monetary union. Investors have thus been attracted to place, what are effectively bets, that the pound will fall, in the hope of making a profit.
Responding to the latest events on the market, the Minister for Finance, Mr Quinn said there had been no change in policy and that it was the Central Bank's job to manage the exchange rate from day to day. However, the Government is likely to be happy to see the currency slip in the ERM band.
The pound had been trading way above all the other currencies in the band. While the method for fixing exchange rates in the move to union has not been decided, the Government feared that if the pound remained very strong in the band, the currency might be locked into monetary union at a rate disadvantageous to exporters. Alternatively, the pound would have had to fall extremely rapidly as monetary union drew closer. Following yesterday's fall, the currency is closer to a level at which the Government would probably be content to see it enter EMU.
There are, of course, risks in allowing the pound to fall. Chief among these is that it could fuel inflation by pushing up import prices. Such fears are likely to lead the Central Bank to try to ensure that the currency does not fall too far too fast. The view in the Bank will be that while the inflation figures so far this year have been low, any significant increase over the balance of the year could bring the rate uncomfortably close to the ceiling for qualification under the Maastricht Treaty. Meanwhile, the Government will be unhappy about the pressure for higher interest rates which is resulting from the latest upheavals in the markets. The Bank may well act to avert the threat of higher bank and building society interest rates, although if money market rates remain at current levels, pressures for a retail rise will quickly build.
But perhaps the clearest message from yesterday's events on the markets is that international investors are increasingly looking on the pound as a potential entrant to monetary union and that the traditional linkage to sterling is continuing to weaken. This will bring new disciplines and challenges for policy makers.