Operation of monetary policy

This article covers the period from April to June.

During the second quarter, activity in the real economy apparently declined further, albeit at a slowing rate, and for the first time there were clear signs of a downturn in underlying inflation. Interest rates were reduced from 12 1/2% in two half percentage point steps in April and late May-and again in July to 11 %. Between end-March and end-June the exchange rate fell, in effective terms, by 3%-taking its total depreciation over the first half of 1991 to almost 5%, largely as a result of the strengthening of the dollar.

The successive cuts in interest rates, together with the trend in sterling, amounted to a significant easing in monetary conditions in nominal terms, although the decline in interest rates may have been rather less in real terms. The approach has been cautious and consistent with official counterinflation objectives, with the authorities underlining their commitment to these objectives by resisting calls to cut rates further or faster. The Bank's money-market operations were at times tightened accordingly, most notably when improvements in the headline RPI in conjunction with the firmness of sterling in the ERM encouraged over-optimistic market expectations on the pace and extent of interest rate cuts.

It is still too soon to be able to assess the effect of the easing in monetary conditions to date, given the long lags before its full impact is felt on the real economy. On past relationships, the stimulus to demand should become progressively more marked as 1991 gives way to 1992; any further relaxation now would have virtually no effect until well into next year.

The fall in sterling's exchange rate index over the quarter mainly reflected the strengthening dollar. In the ERM, the pound remained well away from its limit rates at all times, despite the cuts in UK interest rates. From late May, sterling weakened against ERM currencies on market fears that political and economic concerns might induce the authorities to cut interest rates further and faster than warranted. In addition, some technical selling of sterling was triggered by the fall in the Spanish peseta which lowered sterling's effective ERM floor. However, the scale of this depreciation was contained and market conditions remained orderly throughout. Towards the end of the quarter and early in July, the markets' concerns appeared to diminish and sterling moved modestly back up in the ERM, and was not affected by the reduction in interest rates on 12 July.

Throughout the period since it joined the ERM, sterling has traded comfortably within its bands. This reflects market confidence that the authorities are ready to conduct monetary policy in a manner consistent with ERM membership. While the ERM represents a potential constraint on policy, its requirements have not diverged from what has been seen as appropriate for domestic objectives.

Operation of monetary policy