The necessary improvement in our trading performance depends in turn on a second improvement in our economic behaviour. We must bring down our rate of inflation so that of our principal trading rivals and keep it at that level.
Despite the deterioration in our inflation rate since last summer, we now have a chance of getting near that aim by the end of the next pay round. The recent increase in prices, despite the strict observance of the pay policy, reflects the operation of a vicious circle we have seen more than once in recent years. Even in a period when pay increases are limited, there can be a sharp fall in the exchange rate as a result of excessive pay increases in an earlier period. This fall robs us of the full price benefits which we hoped to gain from pay policy. And if the resulting disappointments makes it difficult to continue pay policy, it threatens us with a further fall in the exchange rate later on. I believe this time we can make a decisive break in the vicious circle and indeed turn it into a virtuous one.
As I shall explain later, the December measures and this Budget together should help to get another round of pay policy. The rise in the exchange rate from the low point it reached last October is worth about 3 per cent. off the retail price index by the end of this year. If, as I hope, my proposals today for income tax relief help to get another round of pay policy accepted, that will help with the future level both of the exchange rate and of prices.
In fact, a satisfactory pay policy can bring prices down in three ways. Provided we have effective price controls, it means lower prices for the goods we produce at home because wage costs are lower. It means lower prices for the goods we import from abroad because the £ sterling is worth more. And these two advantages help to bring down interest rates—which cuts the cost of everything we buy on credit, like housing, and helps employment by stimulating industrial activity and investment. By the same token a free-for-all leading to a wage explosion would send prices rocketing up for three reasons—through higher domestic costs, through a lower exchange rate, and through higher interest rates.