News Release
Currency Puzzles
16 Spetember 1999
A Lecture by Dr Sushil Wadhwani at the London School of Economics on 16 September 1999
In a lecture at the London School of Economics organised by the Centre for Economic Performance, Dr Sushil Wadhwani, an independent member of the Monetary Policy Committee, said that he feared that sterling might stay higher than was assumed in the Bank of England's Inflation Report forecast in August. Consequently, other things being equal, the outturn for inflation over the next two years might be lower than the Inflation Report forecast.
In commenting on the current convention of using the Uncovered Interest Parity hypothesis (whereby the fact that sterling interest rates are above euro interest rates is taken to imply that sterling will depreciate against the euro by an offsetting amount) to forecast the exchange rate, Dr Wadhwani reminded the audience that, historically, this convention had proved to be a poor predictor, and was, somewhat puzzingly, even outperformed by the convention that the exchange rate could be assumed to remain constant (the so-called Random Walk hypothesis).
Some economists believe that sterling must inevitably fall because, when assessed on the basis of conventional indicators like Purchasing Power Parity, or the so-called Fundamental Equilibrium Exchange Rate, "fair value" is in the DM2.30-2.65 region. However, Dr Wadhwani presented a new model which suggested that the markets might have re-rated sterling against the DM because, in recent years, the German unemployment rate has risen relative to that in the UK. The models presented implied that, on the assumption that the prevailing economic conditions persist, the markets might keep sterling at around DM3. However, modelling exchange rate behaviour was exceptionally difficult, and the estimates of sterling's equilibrium value were pretty fragile and uncertain.
Consequently, it was important for the MPC to continue to examine alternatives to the current Uncovered Interest Parity convention, especially as some of the alternatives presented in the lecture imply that sterling might stay stronger than that convention currently implies.
In recognising the difficulties associated with being confident about an exchange rate forecast, Dr Wadhwani pointed out that if, for example, US equities fell significantly, then the models implied that sterling could tumble quite far against the euro. However, it was extremely difficult to forecast Wall Street. Fortunately, a fall in sterling under those circumstances would not necessarily be inflationary and, therefore, there was no need to keep UK interest rates higher than they would otherwise be in anticipation of a stockmarket-induced fall in sterling.
Key Resources
 |
Speech by Dr Sushil Wadhwani Download PDF |
