Commentary: Policy must not be based on hope

The most worrying aspect of sterling's fall to new lows yesterday is the renewed buzz in the market that the Government is happy to see the pound drop. There were even some murmurs, quite possibly from people who had sold sterling short, that the Bank of England had been selling pounds in recent days to nip any rally in the bud.

On this view, a reluctant Chancellor and an enthusiastic Prime Minister are set to pursue a 'competitive pound'. With sterling now nearly 16 per cent below its trade-weighted level just before Black Wednesday this would, if true, be a high-risk strategy.

The first problem with any such policy is that a fall in the pound does not necessarily make British business more competitive in more than the short term. If the price level rises to compensate, there is no gain. True, optimists believe that sterling's devaluation will have a limited effect on inflation because companies will be unable to pass on rising import costs to their hard-pressed customers. But there is little evidence from yesterday's producer prices figures to support such a rosy view.

The first breakwaters against the inflationary tides from devaluation are importers, but they seem to be passing on the rise at a fair clip. Import prices rose by 12.7 per cent between August - the month before Black Wednesday - and December. This was in line with the size of sterling's fall. In the same period the prices paid by manufacturers for fuel and raw materials rose by 9 per cent. As around two-thirds of industry's inputs are imported or priced in dollars, this suggests that importers are successfully passing on the entire fall in sterling.

The City saw a sign of hope in the January factory output price inflation figure, which did not accelerate as feared from 3.5 per cent. This may partly be due to the offsetting slowdown in wage costs, which is certainly encouraging. But it may also be due to the failure of government statisticians to spot when firms apply or end discounts to list prices.

Moreover, it is still early days. Econometric studies suggest it takes at least six months for higher raw material costs to feed through to factory gate prices.

The Chancellor can live in hope, but he should not base policy on it. He would be wise to start dragging his heels about sterling's fall, if only on the grounds that economies are bad at absorbing large changes. A little public intervention might not come amiss, as it would testify to the authorities' concern.

Norman Lamont might also say that interest rates must not get too far out of line with German rates. If he persists in pleasing his backbenchers rather than the currency markets, he could soon find himself unable to please either.