The pound plummeted to a new low against the German mark and a basket of other currencies yesterday. It will be at risk for the rest of the week, with the Bank of England due to publish a warning of higher inflation after the Chancellor's decision last Friday not to raise base rates this month.
After a quiet start to the day, sterling began to fall sharply in heavy afternoon trading. There were rumours of Bank of England intervention to manage the slide.
The pound dropped more than two pfennigs against the mark, to close just below DM2.18. Its value against a basket of currencies dived 1 per cent to a new low of 82.7, after falling by the same amount on Friday.
The currency market was reacting to the Chancellor of the Exchequer's unexpected inaction on base rates on Friday, the day after the Government's local election disaster. A half-point rise from the current 6.75 per cent had been fully anticipated. Many investors saw the failure to act as motivated by politics rather than economics.
Ian Shepherdson, an analyst at HSBC Markets, said: "It looks like the Chancellor has concluded that there are not many votes in pleasing the markets." Steven Barrow, currency economist at Chemical Bank, said: "There has to be an increased danger that the Government will take more risks with the economy before the general election."
Although many City analysts agreed there were arguments for and against another interest rate increase, there is disappointment in the financial markets that the Chancellor, Kenneth Clarke, and the Governor of the Bank of England, Eddie George, did not live up to their previous hardline record.
Paul Mortimer-Lee, chief economist at Paribas Capital Markets, said: "It was the first real test of the Government's anti-inflation strategy, now that inflation has started to go up. They funked the tough decision."
The figure for April retail prices, due out tomorrow, is likely to show a better inflation performance than the previous month. The target measure, the retail price index excluding mortgage interest payments, rose to 2.8 per cent in March. It should fall back because last April's introduction of VAT on domestic fuel will finally stop affecting the 12-month comparison.
However, the Bank of England's quarterly inflation report, also published tomorrow, will show a gloomier forecast than it made in February. The Bank will have to reveal its concern about the effect of sterling's fall since February. The exchange rate is 6.5 per cent lower than it was when the last inflation report was prepared and has resulted in a sharp rise in import prices. The drop in the pound is equivalent to a 1.5 per cent reduction in base rates - reversing the increases since September - according to the Treasury's normal rule of thumb.
So far Mr George has dismissed the pound's weakness as a "wobble". However, City economists are becoming increasingly concerned. Helen Macfarlane of Hoare Govett said: "This is not a repeat of 1992 when sterling fell out of the exchange rate mechanism. The economy is not weak enough now for the pound's fall to have no effect on inflation."
Robin Marshall, chief economist at Chase Manhattan, said: "Sterling's decline has now reached levels where it will bring the counter-inflation strategy into question if the Chancellor does not respond." However, Mr Clarke ruled out an interest rate increase this month.
The market's expectation of an increase in June instead is already building up. The Chancellor and Governor next meet on 7 June. Minutes of their 5 April meeting will be published next Wednesday.
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