Tory hopes of rate cut fillip slide with sterling: Calls for early return to ERM reinvigorated as alarm mounts over economic policy

HOPES of a cut in interest rates to bolster the morale of this week's Conservative Party conference have been dashed by the steep slide in the pound.

Sterling's 10-pfennig plunge last week doused City expectations that the Government would attempt to restore its popularity and head off a further decline in the economy with another post-devaluation reduction in rates.

On Friday, sterling fell almost five pfennigs to end at a record closing low of DM2.4352 - 17 per cent below its old central rate in the exchange rate mechanism. Although the fall was sparked in part by the Bundesbank's decision to keep its key rates unchanged, it was mainly the result of a collapse in confidence among foreign investors.

'Sterling's fall will continue and they'll take it down until it hurts,' warned Keith Skeoch, chief economist at James Capel. His counterpart at Credit Lyonnais Securities, Glenn Davies, added: 'The Government will not dare to raise interest rates during the party conference, so there is simply no upside for sterling; it is impossible to predict the floor.'

Market analysts cite the recent Financial Times leader calling for the resignation of the Chancellor, the damaging row between the Treasury and the Bundesbank, the unappetising prospects for British shares facing a weak recovery, the lack of clear economic policy guidelines and worries about a new rise in inflation.

Not only has sterling's decline killed hopes of a reduction in rates next week, it has made one unlikely for the foreseeable future, at least as long as confidence in the Government continues to fall.

Sterling's weakness has given new impetus to the campaign of pro-European ministers, such as Michael Heseltine, for an early return to the ERM. His warning that life outside the mechanism will be no bed of roses is being borne out by the financial markets, where there is alarm over the absence of a coherent economic strategy.

Norman Lamont may face growing pressure to announce his new policies before 29 October, when he is due to make a speech on monetary policy to the Lord Mayor's annual banquet at Mansion House.

The erosion of confidence reflects scepticism about Mr Lamont's capacity to restore stability and a thirst for a policy anchor to replace the ERM.

Calls for an independent Bank of England, combined with properly defined monetary targets, are mounting.

Neither the Chancellor's hints that he will return to the discretionary monetary policies of the late 1980s, nor signs that the Government will clamp down further on public spending, have reassured the markets.

Although calls for Mr Lamont to quit are not as strong in the markets as in the media, few analysts feel his judgement can now be trusted if monetary policy is to rely on discretion rather than the ERM's rules.

The Chancellor has hinted he will rely on targets for broad and narrow money supply, as well as asset prices - particularly house prices.

But these are seen as a return to the discredited policies of the late 1980s.

Even suggestions that the Government will resort to inflation targets have failed to lift confidence. Bill Martin, chief economist at UBS Phillips & Drew, said: 'I cannot see how a return to a born-again medium-term financial strategy is going to be at all credible.'

The international outlook is also darkening, possibly creating more turbulent conditions for sterling.

A fall in US rates is expected next week and could strengthen the mark further, deepening tensions in the ERM and putting further downward pressure on the pound.

Economists fear that if Europe is forced to maintain high rates to underpin the ERM, Britain's European export markets are likely to shrink further.

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