The Government's overriding economic concern now is the rate at which the pound will be fixed against the deutschmark at the start of EMU. Another concern is the inflationary effects of the pound's recent sharp decline. While sterling remains strong against the deutschmark, these concerns cannot be reconciled: the Government either accepts that inflation will accelerate or revalues the pound. The latter option carries the risk that a subsequent steep fall in sterling will mean an uncomfortably high EMU entry rate for the pound. The Government is praying that sterling will fall sharply against the deutschmark before they make a decision on the entry rate issue, but such a decision may have to be announced as early as next month's ECOFIN meeting.
In an attempt to resolve the dilemma Mr Patrick Honohan of the ESRI has suggested that the preannounced entry rate for the pound should be its current ERM central parity of DM2.41, or the rate against the deutschmark that corresponds to 87p sterling at the time of entry, whichever is the higher. He describes the merits of his idea as follows:
"By imposing this sterling floor, we prevent a further sharp depreciation of the Irish pound against sterling, without exposing ourselves to the risk that we might have to enter at too high a rate against sterling." How would the pound behave if the Government made such an announcement?
At all values of sterling's forward rate for January 1st 1999 above DM2.77, the pound would shadow sterling for the next seventeen months and Ireland would prepare for membership of a monetary union with the deutschmark by pursuing a fixed exchange rate regime vis-a-vis the UK currency.
If sterling moved up above DM3.18, the pound would breach its current ERM fluctuation limits. The Irish authorities could avert this, but only by allowing the pound fall below the 87p floor against sterling proposed by Mr Honohan. Alternatively, they could revalue the pound's ERM parity, but this is precisely what the Honohan formula is designed to avoid.
If sterling fell against the deutschmark the pound would decline pfennig for pfennig with it, at least up to the point where sterling's forward rate against the deutschmark reached 2.77, and would fall further on a trade-weighted basis than it has already year to date. This would lead to a higher inflation rate than is already in prospect.
The current pre-occupation with the pound's EMU entry rate reflects the recognition of how critical to our economic health its sterling exchange rate is. There is an obvious conclusion to be drawn. There is an equally obvious unwillingness to draw it.
In Business This Week yesterday the sense of Mr O'Leary's article was distorted by errors at the production stage.
