Industrial fall halts the pound in its tracks

News of an unexpected decline in manufacturing output sent sterling temporarily lower on the foreign exchanges yesterday. Manufacturers cut production by 1.1 per cent in May, in the biggest monthly decline in nearly four years.

Most economists still expect the Bank of England to nudge interest rates up by a quarter point to 6.75 per cent after its Monetary Policy Committee meets tomorrow and on Thursday, but the manufacturing figures came as enough of a shock to halt the pound in its tracks.

It lost two pfennigs against the mark, falling to DM2.93 when the figures were released, before recovering to DM2.95. The tantalising prospect of 10 French francs to the holiday pound remained just out of reach, with sterling ending nearly unchanged at Fr9.94.

The Office for National Statistics said export levels had held up and were not responsible for the drop in output. It also revised up past output levels from earlier estimates.

But some analysts warned nevertheless that it could be the first hard evidence that the strong pound was damaging industry. Michael Saunders, UK economist at Salomon Brothers, said: "We already know from surveys that export orders have weakened sharply."

The steepest fall within manufacturing in May came in the export-dependent engineering sector, where production dropped 2.3 per cent during the month. A survey by the Engineering Employers' Federation today is expected to confirm a big decline in export orders during the latest quarter.

Production of textiles and clothing fell too, down 0.9 per cent during the month. Beyond manufacturing, there was also a sharp drop in mining and quarrying, but electricity, gas and water output surged by 2.9 per cent.

Output can be extremely volatile month to month, and the suspicion that May's fall was a counterpart of a surprise gain in April was boosted by the detail. Output of consumer durables dropped 3.5 per cent in May after jumping 2.2 per cent in April. Output of other consumer goods and "intermediate" products was little changed.

But yesterday's figures showed that in the three months to May manufacturing output was virtually flat. It was a modest 1.7 per cent higher than the same period a year earlier.

David Mackie, an economist at JP Morgan, predicted this would not be subdued enough to deflect the Bank from raising base rates for the third month running.

"If you look across the whole range of indicators, manufacturing is doing all right. It is not booming like services, but it is not teetering on the brink of recession," he said.

Recent business surveys have indicated that the strength of home demand has been enough so far to offset weakness in export orders. Yesterday's figures were therefore out of line with other indicators.

Most City analysts think the Bank of England's experts on the Monetary Policy Committee will be swayed by the past month's fresh evidence that consumer spending is on the boil. The news that nearly a quarter of the people receiving free shares from the Woolwich are selling them immediately, cashing in pounds 1bn, will have done nothing to reassure the Bank.

"It remains likely the manufacturing sector will be sacrificed on the altar of consumer buoyancy," said John O'Sullivan at NatWest Markets.

Simon Briscoe at Nikko Europe said the weakness of manufacturing would restrain the Bank. "Another two urgent quarter point rises could be the extent of the increase this year," he said.

The level of base rates is expected to climb to 7.5 per cent by next spring.