By Philip Uglow and Gavin Friend
LONDON (MktNews) - Bank of England Governor Eddie George said Wednesday that he welcomed the Chancellor's cautious approach to making the assessment of the five economic tests for possible UK entry into the single European currency.
Speaking at the annual Mansion House dinner in the City of London, George said "So I very much welcome the considered and cautious approach to making the assessment of the five tests, which the Chancellor set out this evening."
However, George repeated recent comments that the current external environment and in particular the weakness of the euro exchange rate was "a potentially serious obstacle to early entry."
George also reiterated recent comments that the UK economy would benefit from a stronger euro in terms of helping domestic monetary policy and also with respect to joining the single currency. He added that at some point the euro "surely must" recover.
"There's no question... that what we would like to see both in the context of our current monetary management and if we are to join the euro, is a combination of a pick up in the global economy and a recovery in the euro exchange rate," George said. However, he professed that he was unable to say how this could be brought about.
George, like fellow MPC member Mervyn King yesterday, outlined the problem of growing imbalances in the UK economy adding that they cannot continue to grow indefinitely.
"We have continued to see a growing imbalance between the internationally exposed (particularly euro exposed) sectors, which have been having a rather torrid time, and the more heavily domestically-orientated sectors, which have been doing rather better", George said.
He noted that although monetary policy was not able to directly affect the external influences on the economy, it could encourage growth of private sector domestic demand adding that the BOE had already done this with its recent 75 basis point easing in monetary policy.
However, he warned that such a policy was not without risks, adding that it could lead to greater imbalances in the economy, "at some point the elastic is likely to break quite possibly through a sharp exchange rate adjustment," George said.
Having deliberately stimulated domestic demand George warned that the BOE might have to rein it back, although given its momentum it might be difficult to stop. George said, that this explained the BOE's caution in moving interest rates down.
Noting that most commentators saw a lower level of sterling as necessary for EMU membership, George implied that a recovery in the euro would be a panacea for both domestic monetary management and possible membership of the single currency.
Repeating earlier comments, George said that a recovery in the euro would cause sterling to weaken against the euro but "strengthen against the dollar and other currencies, leaving our overall effective exchange rate closer to where it currently is. That would have less impact on our domestic rate of inflation."
Turning to the US economy, George repeated recent comments that he was "modestly optimistic", but noted that he was very conscious of the downside risks.
He added that it was widely expected that the US dollar would fall given the slowdown in the US economy as capital flows moderated and earnings expectations weakened. While that has not happened, George said that given the size of the US external imbalance, "it is difficult to see how an exchange rate adjustment can ultimately be avoided."
In this respect George noted that even though the Federal Reserve had cut rates by 250 basis points this year the change in interest rate differentials between the US, Europe and the UK had not harmed the dollar.
"That ought to be a salutary lesson to those who imply that monetary policy can be directed to controlling both inflation and the exchange rate at the same time," George said.