This article covers the period from July to September.
On 16 September, in exceptionally turbulent market conditions and after heavy official purchases of sterling, the United Kingdom suspended sterling's membership of the ERM. The Banca d'Italia also ceased its intervention in support of the lira and the peseta was devalued.
For the first eighteen months sterling's membership of the ERM was helpful in enabling base rates to be reduced from 15% to 10%, as activity slowed and inflation fell. These reductions were possible despite increases in German official interest rates to meet the inflationary and fiscal consequences of reunification. Membership of the ERM enabled the nominal short-term interest rate differential with Germany to narrow to less than 20 basis points while the wide ERM band provided some scope to accommodate the diverging needs of the UK and German economies.
Over the spring and summer, domestic recovery continued to prove elusive, while the consequences of German reunification were clearly greater than earlier envisaged. As German monetary growth remained rapid, there seemed little near-term prospect of an easing of German interest rates and indeed the German discount rate was raised again in July. Moreover, the policy mix in Germany relative to that in the United States and Japan caused the deutschmark, and therefore the whole ERM grid, to appreciate against the dollar and yen. It therefore became increasingly apparent in ERM countries where activity was weaker than in Germany that the conflict between the internal objectives of monetary policy and the exchange rate commitment would be prolonged. In the United Kingdom, the maintenance of sterling's position in the ERM constrained the scope for cutting nominal interest rates below those in Germany. As a result, real interest rates rose as the domestic inflation outlook improved.
Operation of monetary policy