begun to side somewhat tentatively with the optimists ; but some of the survey evidence of consumer and business confidence, on the other hand, supports a more pessimistic view. the truth is that none of us knows with any great confidence just how the us situation will evolve. for what it is worth i remain modestly optimistic, but i am very conscious of the downside risks. the outcome is obviously the major uncertainty affecting us all. the other major external influence on the economic situation in this country is the development of the exchange rate. depending on who you speak to sterling is variously described as dangerously weak, at a 15 - year low, against the dollar, or as unsustainably strong, close to its peak, against the euro. the truth is that sterling's effective exchange rate has been relatively stable for most of the past 2 ½ years – at about 105 on the standard index, plus or minus 5 %. the bilateral rates that are frequently quoted in fact tell us very little about sterling : they are essentially a reflection of the persistent general strength of the dollar on the one hand and the persistent general weakness of the euro on the other, resulting from sustained capital inflows to the united states in large part from the eurozone. it was widely expected that, with the slowdown in the us economy, and associated weakening of us earnings expectations and stock prices, these capital flows would moderate, causing the dollar to weaken and a corresponding recovery in the euro. that clearly has not, yet, occurred, although – given the size of the us external imbalance – it is difficult to see how an exchange rate adjustment can ultimately be avoided. in the meantime, the stronger dollar – and higher oil prices – have added to inflationary pressures elsewhere. but in our own case this effect has been offset by the weakness of the euro – or by sterling's bilateral strength against the euro, if you prefer – which has dampened both external demand and our domestic price level. the result of these external developments – the global economic slowdown and the pattern of exchange rates taken together – for us has been that, notwithstanding only a rather modest slowdown of our overall economy, we have continued to see a growing imbalance between the internationally - exposed ( particularly the euro - exposed ) sectors, which have been having a rather torrid time, and the more heavily domestically - oriented sectors, which have been doing rather better. the weakness of manufacturing alongside continuing growth in the services sectors is

a crude reflection of this imbalance. with inflation running somewhat below the chancellor's symmetrical 2½ % target, and with developing uncertainties about the continuing strength of domestic demand, the mpc was in a position to respond to these developments by reducing interest rates earlier this year. in fact we cut rates by ¾ %, while the federal reserve cut much more aggressively, by 2½ % over much the same period, and the european central bank by just ¼ % – reflecting the different overall monetary conditions as they saw them in their respective currency areas. you might suppose that these relative interest rate movements would have encouraged the dollar to weaken against sterling and by more against the euro – and given the pattern of international imbalances it would have been helpful if they had. but, in the event exchange rates moved in the wrong direction, illustrating the unpredictable – even perverse – relationship between relative interest rate and exchange rate movements at least in the short term. 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! so there is not much that we can do directly, through monetary policy, to affect the various external influences weighing upon our economy. but we can attempt to offset their effects, by encouraging the growth of private sector domestic demand to try to keep overall demand in the economy growing in line with potential supply. and that in effect is what we have done through our recent interest rate cuts. this approach is not, however, without risks. it involves accepting – at least while the dampening external influences persist – a growing imbalance between the internationally - exposed and the domestically - oriented sectors. if we did not accept that, then overall demand and output would be lower, and inflation would tend to fall further below target. but the imbalance cannot continue to grow indefinitely. at some point the elastic is likely to break – quite possibly through a sharp exchange rate adjustment. and at that point, having deliberately stimulated domestic demand growth, we would need to rein it back. but we could then find its momentum hard to stop. i am not suggesting that we are necessarily approaching that point. domestic inflationary pressures, including wage pressures, have so far remained reasonably subdued and it is crucially important that that should continue. but it does explain our caution in moving interest rates down. somewhat similar concerns explain my reaction to recent speculation that the government would now make a strong push for early entry to the euro. i