The Bank of England’s perspective
As the action was performed based on financial
speculation, it is crucial to revise the basic theory related to currency
market. In 1990s, ERM imposed a limitation band that constrained monetary
exchange fluctuation between each other of 2.5% on all members (except Italia,
which was permitted a fluctuation of 6%). This implied the basic structure of
exchange rate system from European Monetary Union (EMU): crawling peg (or
semi-pegged system). In the structure, inflation must be similar to the pegged
currency “shadowing” Deutsche mark (DE) and intervention will be unlimited
assistance on the credit line. However, the sterling was thrown to the money
basket of EMU without careful consideration. Consequently, in 1992 the pound
entered the mechanism at DE2.95/£ with allowed fluctuation band of (2.87,
3.02).
The very first trouble turned out to be relative greater
British inflation compared to Germany. To have an inside view, a theory
analysis is necessary. Fisher (1930) said that nominal interest rate should
reflect expectations of the rate of inflation.
In formulae, the nominal interest rate is a sum of
expected real interest rate and expected rate of inflation: I(t) = Ie + π e
.
To understand the inflation, the interest will make a great sense. In 1990, the reunification of East and West Germany created waives on European politics and economics. Especially, the German government decided exchange rate between Ostmarks and Deutsche to be 1:1, as an attempt to get Eastern Lander joined German economics even though power purchase parity (PPP) of Ostmarks was less than PPP of Deutsche marks. Hence, the German government announced a tight monetary policy of low money growth and high interest rate. However, this policy was not good news for sterling, which was suffering from high interest rate at that time, that was almost three times more than Germany’s. Indeed, the British interest rate was at a high level of around 10%, but then in September, 1992 they hiked the rate up to 12%, even 15% according to a promise of UK’s Prime minister and cabinet members. Why they increased the nominal interest rate although it was supposed to be decreased? One reasonable answer is that they tried to tempt speculators to buy pounds. However, the speculators who had never been naïve did find a sign of fat cheese, and accelerated their investments by selling pounds. By 19:00 pm September 16, 1992, Norman Lamont, announced Britain would leave the EMR, kept the rate at 12%. There was no sentence from speculators; perhaps they were so busy counting the fat profit. (The next day the interest rate was back on 10%, anyway).
To understand the inflation, the interest will make a great sense. In 1990, the reunification of East and West Germany created waives on European politics and economics. Especially, the German government decided exchange rate between Ostmarks and Deutsche to be 1:1, as an attempt to get Eastern Lander joined German economics even though power purchase parity (PPP) of Ostmarks was less than PPP of Deutsche marks. Hence, the German government announced a tight monetary policy of low money growth and high interest rate. However, this policy was not good news for sterling, which was suffering from high interest rate at that time, that was almost three times more than Germany’s. Indeed, the British interest rate was at a high level of around 10%, but then in September, 1992 they hiked the rate up to 12%, even 15% according to a promise of UK’s Prime minister and cabinet members. Why they increased the nominal interest rate although it was supposed to be decreased? One reasonable answer is that they tried to tempt speculators to buy pounds. However, the speculators who had never been naïve did find a sign of fat cheese, and accelerated their investments by selling pounds. By 19:00 pm September 16, 1992, Norman Lamont, announced Britain would leave the EMR, kept the rate at 12%. There was no sentence from speculators; perhaps they were so busy counting the fat profit. (The next day the interest rate was back on 10%, anyway).
(to be continued)
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