View from City Road: Chancellor should stand by to cut rates

The collapse, in effect, of the exchange rate mechanism has a mixed impact on British business. By giving ERM members more freedom to pursue their own monetary policy regardless of the preferences of the Bundesbank, it should allow most European interest rates to fall. That will encourage output and hence demand for British goods. However, lower European interest rates may also reduce the value of the franc and other currencies against sterling. The resulting loss of British competitiveness will tend to limit the benefit of reviving markets to UK exporters.

As always, the timing is the key. Financial markets react much more quickly than investment or consumer spending. So a rise in the pound may occur quickly, and may depress Britain's export prospects before reviving demand in our Continental markets improves them.

True, France and the Iberian countries can be expected to react relatively quickly in cutting interest rates: Portugal made a start yesterday. Germany may cut interest rates more rapidly too when the Bundesbank is convinced that the rise in the mark will reduce import prices. But the Buba has only two speeds: slow and very slow.

The effect of such Euro-rate cuts will take time to influence activity. Interest rate movements are powerful, but the leads and lags are long. The Continental consumer is less sensitive to changes in interest rates than Britain, because mortgage debt is much lower. So the outlook for this year is unlikely to change. And next year, growth may be only half or one percentage point better than previously predicted.

Given the delay that is likely in any positive impact on the UK economy, the Chancellor should be ready to cut UK interest rates if sterling strengthens sharply in the wake of the currency turmoil. Even though the recovery looks well-established, it is important that Britain's trading sectors should be able to help fill the hole in the balance of payments. If that implies that the recovery of domestic spending will be too rapid, the correct response will be more public spending cuts or higher taxes.

Indeed, such fiscal tightening may well be a widespread European response to a recovery securely generated by short-term interest rate cuts. The outlook for fixed-interest securities should therefore be good on two counts. First, prices will benefit as investors chase higher yields in longer maturities. Second, fiscal tightening may help to curb governments' appetite for European savings. As bond prices rise, share prices should sympathise.