Sterling has recently found itself trapped between a rising dollar and a plunging euro, confronting monetary policies with difficult choices. At an earlier stage, in the context of the sterling/ERM crisis in fall 1992, sterling had undergone some major correction, falling against the dollar from 1.95 to 1.45 and against the Deutschmark from 2.65 to 2.30 (with the "synthetic euro" rising from 0.73 to 0.85, see our adjacent Crossrates page), to what had been considered sufficiently "competitive" levels at the time. When the dollar appreciated strongly against the yen (and other currencies) between 1995 and end-1998, sterling tended to follow the dollar higher, also because the UK's business cycle stayed much more in sync with the U.S. than with continental Europe. For example, it managed to climb back to 3 Mark, giving rise to renewed industrial competitiveness concerns in the process.

Since the introduction of the euro at the beginning of 1999, sterling has had to live in the worst of all possible worlds: being constrained by the falling euro against the dollar, thereby aggravating import cost pressures with a domestic economy (unlike Euroland's) already operating at capacity, but without resolving the UK's "competitiveness problem" on European markets. On the contrary, against the Deutschmark (now subsumed under the euro) it even rose further to 3.25.

Ever since the UK broke free from the European exchange rate system in 1992, the Bank of England has chosen to tie its credibility to the success of its new, domestically oriented "inflation targeting" framework. To keep inflation within a low and stable 1 1/2-3 percent range (excluding the cost-of-living effect from changes in mortgage rates), has been the sole monetary policy objective. A priori, this objective could have been perfectly compatible with broad exchange rate stability as well, since inflation in both Europe and in the US has been running at very similar rates. However, while so far the inflation objective has been consistently met, the cumulating divergence between the dollar and the euro - increasingly disconnected from inflation differentials - also implied a growing imbalance in the UK between strong domestic demand and deteriorating export competitiveness both on European markets and vis-à-vis European competitors worldwide.

For a while, some export weakness was welcome to offset excessive domestic demand and emerging wage pressures, but in the course of the year 2000 the business cycle including interest rate expectations peaked. Therefore some re-balancing of demand in favor of exports would now have been appropriate, and the "competitiveness" aspect of the exchange rate became the dominant concern once again. A depreciation of sterling against the euro was called for, but impossible to achieve in light of the steep fall of the euro itself, unless interest rates would have been aggressively brought down to continental European levels. The latter, however, was ruled out by the untouchable constraint of the still relatively new inflation target, on whose permanent achievement the re-gained credibility of British monetary policies more than ever depends.

A policy conflict between domestic and external (export- or balance-of-payments-related) requirements is nothing unusual in the management of a medium-sized open economy - certainly not under a formally or informally fixed exchange rate. However, the UK's inflation targeting framework had been designed precisely with the goal to provide an "optimal" solution for such a case. By focusing exclusively on domestic price stability, monetary policies were not to be burdened with potentially competing exchange rate objectives but still obliged to adjust policies in response to exchange rate changes to the extent the latter affected the domestic inflation outlook. What had, however, not been foreseen was the possibility of strongly divergent bilateral exchange rate movements, each with very different implications for inflation and for the real side of the economy. Sterling-euro matters for UK output more than sterling-dollar, while sterling-dollar - through the channels of import costs, bond yields and inflation expectations - matters more for inflation than does sterling-euro. Thus, the old conflict between "external" and "domestic" requirements, which the inflation targeting framework had hoped to be able to resolve, has returned through the backdoor by confronting policies with the question "which" of the two bilateral exchange rates to focus on and to respond to. (The synthetic concept of an "average" or "effective" exchange rate is not very helpful under these circumstances, because the implied output costs of "sticking" to the inflation target will vary greatly depending on the pattern of bilateral exchange rates.)

Conceptually, the UK may have to consider one of two options to escape from this dollar-euro trap: either to join EMU and adopt European interest and inflation rates; or to join NAFTA and re-direct trade flows towards North America.

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