The stock market surged to a record on the belief that interest rates might soon be cut to help keep the pound competitive, especially with lower rates expected in Germany.
The Chancellor of the Exchequer and the Governor of the Bank of England discussed a rate cut at their monthly meeting, but the Treasury's monthly monetary report suggested little need to cut rates so far to boost recovery.
The FT-SE index of 100 leading London shares ended the day 38.8 points higher at 3,520.3. The gilts and money markets were much less convinced about an early rate cut.
The foreign exchange reserves rose by an underlying dollars 205m last month, the biggest increase for six months. The figure was well above the average City forecast of a dollars 90m increase. Reserves totalled dollars 43.4bn (pounds 29bn) at the end of the month.
The pound dropped on the announcement of the figures, closing 0.95 cents lower at dollars 1.4955 and 0.89 pfennigs lower at DM2.5940.
Against a basket of currencies sterling shed 0.3 of a percentage point to 82 per cent of its 1985 value. Interest rates were last cut in late November with the pound at 81.4 per cent on this measure.
'If we do see a sharp upwards movement in the pound - perhaps because the Bundesbank cuts interest rates - it does suggest that the authorities might use the interest rate weapon,' Don Smith, of Midland Global Markets, said. Most City analysts believe that a rate cut would come in March or April, when a blip in inflation has passed and tax increases are biting.
George Magnus, of Warburg Securities, agreed that the reserves 'suggest that the authorities have been quite active in intervening to stem the rise in sterling'. He said the Bundesbank was likely to cut German interest rates by half a point at its council meeting today.
Mr Magnus said the pound could rise towards DM2.65 on further news of a steady, non-inflationary recovery. But not all analysts were convinced by the talk of intervention. Steve Barrow, of Chemical Bank, said the Bank might have been selling small amounts of sterling but it did not appear to be trying to defend a particular level.
Meanwhile, another strong rise in the US government's main forecasting index - its fifth monthly increase in a row - suggested the US economic recovery would continue at least until this autumn.
According to the Commerce Department, the index of leading economic indicators jumped 0.7 per cent in December, making a five-month gain of 2.5 per cent, more than for any comparable period since 1983, when the Reagan boom was moving into top gear.
Analysts are taking the latest reading as further confirmation that 1994 will show overall growth of at least 3 per cent. In another sign of robust growth new home sales climbed 9.7 per cent in 1993, their best gain since the late 1980s.
The latest data could hasten the much anticipated action by the Federal Reserve to nudge short-term interest rates higher as a pre-emptive strike against inflation.
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