Onslaught on pound could force rates rise

The pound faces a new assault today following the surprise decision by the Chancellor, Kenneth Clarke, not to raise interest rates on Friday. Some analysts believe the pound's weakness may force him into an embarrassing early reversal of that decision, with rates going up in the next two weeks.

Although the London market is closed today for the VE Day holiday, many dealers will be at their desks to track trading in the rest of Europe, the Far East and North America, where economists believe there could be further selling after sterling neared its all-time low last week.

David Walton of US investment bank Goldman Sachs said yesterday: "I think there was a tendency for the pound to weaken on Friday and there is no reason for that to abate any time soon."

Goldman expects the pound to fall into the target range of 2.10 to 2.12 against the mark against Friday's closing rate of 2.1949. A further danger this week would be any tendency for the dollar to weaken further, following Friday's employment figures. Those were interpreted as showing the US economy slowing last month, reducing the likelihood of rate rises across the Atlantic to boost the currency.

Sterling ended over two cents lower on the day, although it was close to its nadir of 2.1790 at one stage. Its trade-weighted value slumped to a new low of 83.6.

The cause of the weakness was Mr Clarke's decision to hold rates, which was widely seen as indicating disagreement with Eddie George, Governor of the Bank of England, over monetary policy. It is thought likely that Mr George pressed for a rate rise in view of economic signals showing rising inflationary pressures in the economy, but was rebuffed by the Chancellor.

Observers say the Bank of England's inflation report and retail price inflation figures on Thurday will be crucial to the debate. Any suggestion of a deterioration in the outlook, or that the Government's inflation targets are likely to be missed, will be taken as evidence that the Government's firm anti-inflationary stance is being weakened by political considerations following the Conservatives' drubbing in last week's local elections.

Roger Bootle, chief economist at HSBC Markets, said that if the inflation report strongly highlighted the danger from inflation, rates could have to move up quite sharply. "I think there is a fair chance we will get a rise in rates in the next two weeks."

The latest crisis was "entirely of the Government's own making" and resulted from its decision to publish inflation targets while attempting to pass more authority in monetary policy-making to the Bank of England.

Mr Bootle described the 1-4 per cent inflation target, later reduced to 1 to 2.5 per cent within the life of the current Parliament, as "pretty ludicrous".

"If they had sensed the route it was going to take, it would have been much better to have found a way of amending the target, but to have kept the target and then not done the things necessary to achieve that target is dangerous."

His own view was that the inflation danger was only short-term. Despite that, the Government was in danger of undermining the credibility of its policy, which was signalling that rates should go up.