Major in crisis talks on sterling: City fears ministers will be forced to raise interest rates, damaging economic recovery

THE PRIME Minister and the Chancellor will hold crisis talks at Downing Street today as the pound faces renewed pressure in the markets which could force up interest rates.

Their aim is to reassert a firm grip on the economy and restore confidence in their strategy for holding sterling within its agreed bands in the European exchange rate mechanism (ERM).

The City fears that the Government will be forced to raise base rates by 1 percentage point or more from 10 per cent to make sterling more attractive to international investors.

Such a rise would probably spur banks and building societies into a wave of mortgage rate increases. It would also deal a blow to fragile consumer confidence, further postponing the revival in high street spending on which the Treasury is relying on to help economic recovery.

The Government hinted it was expecting intervention by the central banks of other ERM countries to support the pound when markets open today. But economists believe that they would not do this indefinitely. Bank of England officials will hold a telephone conference at 8.30am with their counterparts in other European central banks as the pound threatens to fall to its floor in the ERM.

The Bank's first line of defence is expected to be heavy intervention in the currency markets. It has reserves of pounds 23bn of gold and foreign currency to prop up the pound.

Ministers also made it clear that they were prepared to raise interest rates if necessary, in spite of an expected backlash from Tory MPs, the opposition parties, home owners and businesses.

In private, ministers were alarmed but not panicking at the prospect of an interest rate rise. 'The housing market has coped with higher interest rates before and it will cope with it again,' said one. But a senior Tory MP, Sir Rhodes Boyson, called for 'compassion' from the Government for householders who may face repossession if mortgage rates are raised.

Ruth Lea, chief economist at Mitsubishi Bank, believes there is a 50-60 per cent chance that rates will have to rise. 'The prospects of another bout of economic weakness would be high. You might see the economy shrink at least 1 per cent this year with precious little growth next year. That really is a slump', she added.

Gavyn Davies, chief economist at Goldman Sachs, argues that a

1-point base rate rise would 'delay but not fatally damage the recovery'. But he believes Britain could even be forced into raising rates by 2-4 points as Italy has.

The rules of the ERM demand that the Bank prevent the pound from falling through its floor of DM2.7780. On Friday it fell to its lowest level against the German mark since joining the system in October 1990, dropping below the psychological barrier of DM2.80 in late trading.

The pound has been weakened by gloomy economic news in Britain and fears that the French will reject the Maastricht treaty in next month's referendum. It has also been caught in the crossfire between the strong mark and weak US dollar.

Peter Fellner, economist at NatWest Capital Markets, believes the Government has made the pound's predicament worse by giving the impression that it will do anything to avoid higher interest rates. 'The cutting of rates on National Savings to avoid a mortgage rate rise was an unnecessary fiasco', he said.

Labour renewed its call for a cut in interest rates with realignment of sterling in the ERM.

Treasury ministers refused to speak publicly about the crisis yesterday to avoid heightening speculation when the markets open this morning.

Devaluation of sterling was ruled out by Gerry Malone, deputy chairman of the Conservative Party, on the BBC radio's The World this Weekend. 'I have every confidence the Government will take the determined action that will be necessary - whatever it is - as the markets open tomorrow to make sure that we maintain our position and our policy.'

Mr Malone said that before entering the ERM, Britain was 'shadowing other currencies without the strength that the ERM gives us - the strength of intervention of our colleagues within the mechanism who are obliged to help us in the market place. Now we can do it within the ERM.'

John Major flew back to Britain from his Spanish holiday last night, and spent the night in his Huntingdon constituency before travelling to London today.

Norman Lamont will return from Tuscany today and go straight to No 11 Downing Street. Michael Portillo, Chief Secretary to the Treasury, has also returned from his holiday.

The Bank's firepower, page 20

Gavyn Davies, page 21