Pound's slump heralds rate rise

Interest rates look set to rise by a further half point early next month after the pound touched an all-time low against the mark yesterday and new details emerged showing that the Chancellor and Governor of the Bank of England are worried about sterling's weakness.

On the foreign exchange markets the pound's index against a basket of other currencies hit a record low of 83.6 before recovering to close at 83.8. The previous low was 84, reached after sterling tumbled out of the European exchange rate mechanism in September 1992.

In early March the index stood at 86. It has now fallen by more than 5 per cent this year. Sterling also hit a new low of DM2.1790 yesterday compared with DM2.2070 on Tuesday.

Other European currencies also weakened sharply against the mark yesterday, dragged down by the French franc. It has come under pressure in the week ahead of the first round of the French presidential vote, thanks to fears that the front-runner, Jacques Chirac, would break the franc's strong link to the German currency if elected. The franc fell to 3.5517 against the mark, down from 3.4855.

The dollar came under direct fire too. It started the European trading day below 80 yen, prompting the Bank of Japan to intervene heavily in the market. It later revived to trade around Y81 and DM1.3570.

Concerns over the pound's fall against the European currencies emerged with the details of the meeting on 8 March between Kenneth Clarke, the Chancellor, and Eddie George, Bank of England Governor,published yesterday. It revealed their concern about sterling's weakness, even though they decided that an increase in interest rates then would be premature.

The Governor said the strains in the currency markets could last for some time. If the effect on the pound persisted, it would need to be taken into account in setting monetary policy. The Chancellor agreed that "developments in exchange markets would have to be kept under review".

Steve Barrow, currency analyst at Chemical Bank, said: "The pound is not at the centre of attention in currency markets. Its weakness was a by-product of the mark's strength against all comers - particularly the French." But Gerard Lyons, chief economist at the securities firm DKB International, said: "The minutes suggest we should not be surprised by an interest rate rise in response to the pound's problems, even though there is no domestic reason to be concerned about inflation."

The financial markets generally leapt to the same conclusion. Short sterling, the futures index used to bet on short-term interest rate moves, fell sharply, pointing to base rates above 7.5 per cent before September.

Adam Cole at James Capel said: "To miss an opportunity to raise interest rates against this background would take huge risks with the credibility of monetary policy." The next monetary policy meeting will be held on 5 May, the day after the local government elections and the week before the Bank's quarterly inflation report is due out.

Better-than-expected US trade figures did not help the dollar, with the markets focusing more on the lack of progress in US-Japan trade talks. The deficit in trade and services bounced from a record $12bn shortfall in January to $9bn in February. The closely watched bilateral deficit with Japan narrowed slightly to $4.71bn.