AFTER heavy selling in the Far East overnight, sterling plumbed new
depths on European markets yesterday. Measured by its trade weighted
index it fell from 78.2% of its 1985 value on Friday night to 77.4, and
was at one point down at 76.7. By contrast share prices soared and the
FTSE-100 share index is now within 10 points of its all-time high.
The pound has lost nearly 16% of its international value since the end
of August. If the pound continues at these levels or if it falls
further, the devaluation will have been greater than the one in 1967.
The last time sterling hit an all-time low (77.8) on the foreign
exchange markets was November 12, the day of the Autumn Statement when
interest rates were cut from 8% to 7%.
Thereafter, it recovered well on the perception that the Government
intended to bide its time before considering fresh action after the
three 1% cuts in interest rates since the pound was ejected from
Europe's exchange rate mechanism.
That perception proved to be wide of the mark. Last week's further 1%
reduction, taking base rates down to a 15-year low of 6%, was widely
interpreted as a sign of panic in the Government's ranks.
In the City, there had been expectations that 1% would be lopped off
base rates at Budget time to compensate for the fact that the Chancellor
of the Exchequer was in no position to cut taxes and might even have to
raise them.
The week before last, disappointing retail sales figures for December
and an alarmingly sharp jump in unemployment for the same month
encouraged hopes of lower interest rates, but the cut came with
surprising speed and wrong-footed the markets.
City economists quickly assumed interest rates would still be cut by a
further 1% at Budget time, and a number even saw them falling
subsequently to 4% or even 3%.
The perception is that either the Chancellor or the Prime Minister (or
both) has decided to stimulate economic recovery at all costs,
regardless of the objective of confining underlying inflation, currently
3.7%, to its 1% to 4% target range.
In a weekend circular, Goldman Sachs's influential chief economist,
Gavyn Davies, one of the Treasury's panel of economic advisers, admitted
to being surprised by the timing of the latest cut in interest rates.
He went on to forecast that base rates would fall to 5% by the second
quarter of this year, and 4.5% by the end of the year. Nor would he be
surprised to see even lower interest rates by then.
Almost every independent economist believes that 6% is not the bottom
of the interest rate cycle. Into this cockpit of speculation, the Sunday
Times gave headlines to a story claiming that interest rates would fall
to 4% and that the Prime Minister had taken over the running of the
economy from Norman Lamont.
The report was denied by Downing Street, but it had too much of the
ring of truth about it not to influence trading on foreign exchange
markets. In the event, the effect was quite dramatic.
Sterling fell to an all-time low of DM2.3550 in overnight trading. It
later recovered some of this loss, but still ended the day about
one-and-a-quarter pfennings below its Friday night level at DM2.3760. In
fact, the big fall occurred against the dollar where sterling lost over
three cents to $1.4550.
Gavin Davies concedes that the most likely risk to his own forecast of
even lower interest rates is a collapse in sterling, forcing the
Government to raise base rates to defend the pound.
But he reckons that a European recession and developing weakness in
the Deutschmark and other European currencies will avert a sterling
crisis. Instead, he expects ''an orderly, though quite large, decline in
sterling with particularly large falls against the dollar and the yen.
Other economists are not sure. In yesterday's Herald, we recorded the
fear of National Westminster's chief economist, David Kern, that by next
year interest rates will be back up to 7.5%.
In another weekend circular, economists at James Capel specifically
asked if 6% was sustainable. Keith Skeoch and Adam Cole argued that a
further devaluation of the exchange rate could help foster revival in
the second half of the year.
But they expressed grave doubts that rates of 6% or less could be
sustained for more than a few months at the most. The Capel economists
claim the move to 6% base rates has opened up the largest interest-rate
differential with Germany since 1973.
Over the last 20 years, the UK has never been able to maintain such a
large differential for longer than a couple of months. ''The exception
was in the early 1970s, which laid the foundations for the Barber
boom.'' With the final twist being delivered by the hike in oil prices,
that resulted in UK inflation of 25% for more than a year.
In contrast to the sorry state of sterling on the foreign exchange
markets, shares celebrated the latest turn of events. International
stocks, like BAT Industries, were to the fore. Their overseas earnings
are worth more in sterling the further the pound drops. The Footsie
jumped 44.4 points to 2851.6.
Lower interest rates are of direct benefit to business and encourage
hopes that the recovery, as yet still born, may eventually build up to a
decent pace. The stock market does not mind a bit of inflation either as
it devalues corporate debt piles.
There was no major rights issue yesterday to upset the applecart. At
current levels, the stock market is vulnerable to a further rash of
these. It may also have second thoughts at the patchy nature of any
recovery evidence which will at best emerge in the next few months. The
biggest blow, however, would be a sterling crisis, forcing the
Government to do a U-turn on interest rates, before any recovery is
firmly established.
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