The Sterling Crisis: Shares soar after 2% rate cut

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THE CABINET decided yesterday that Britain should re-enter the European exchange rate mechanism as soon as conditions allow. But official sources said that Britain could remain outside for several months until German interest rates begin to come down.

The City became increasingly convinced that an early return to the ERM was unlikely as the pound plunged to an all-time low against the German mark, in an effective 10 per cent devaluation from its old central rate in the system.

The embattled Chancellor, Norman Lamont, reversed Wednesday's rise in interest rates from 10 to 12 per cent. The belief that the pound will continue to float for some time fostered optimism in the City that interest rates could be cut to about 8 per cent by the end of the year. But a meeting of the Bundesbank council left German rates unchanged.

Hopes of lower British rates helped to add nearly pounds 22bn to the value of London shares in the most frenzied trading seen by the stock market since the crash of 1987. The FT-SE index of 100 leading company shares rose by 105.6 points to 2,483.9, the biggest one-day jump since the Conservatives' election victory.

The financial markets ignored disappointing unemployment and factory output figures. The jobless total rose by 47,400 in August to 2.81 million. This was the largest rise since January and took the total to its highest for five years. Factory output in the three months to July was flat compared with the previous months, suggesting no recovery in manufacturing industry.

City and academic economists said yesterday that the fall in the pound and any cut in interest rates would help to lift the economy out of recession. 'The ironic thing is that we may get an economic recovery because the Government's policies failed,' said Ruth Lea, chief economist at Mitsubishi Bank.

However they warned that the gain might be short-lived and that inflation would rise. 'What is going on is obviously good news for the recovery, but price stability is now out of the question. The recovery will not be constrained, so we are back to stop-go policies', said Keith Skeoch, of the City firm James Capel. He added that the devaluation meant exports and business investment would be more important in pulling the economy out of recession than high-street spending.

An official said the Treasury would conduct interest rate policy primarily to pursue low inflation, based on movements of the pound and measures of the amount of money in the economy. If that policy proved compatible again with ERM membership, as the Government hoped, the pound would rejoin the system.

The ERM remained under pressure yesterday despite the Italian government pulling the lira out of the system until next Tuesday and a 5 per cent devaluation of the Spanish peseta. The French, Irish and Danish central banks were all forced to launch support-buying operations to defend their currencies. However, none faced the same degree of pressure that forced sterling and the lira to leave the system.

The Bank of England let the pound fall as far as the market wanted. The most dramatic decline took place in overnight trading in New York and Tokyo but the London market remained uncertain until yesterday lunchtime. The pound ended the day at DM2.6279, having traded as low as DM2.60. The 14.71 pfennig fall from Wednesday's close was the largest since the pound was last devalued in 1967.

The dollar benefited from the confusion in the ERM and fears that the system might disintegrate completely after a 'no' vote in Sunday's French referendum on the Maastricht treaty. The pound fell nearly 6 cents to dollars 1.7800, but the dollar fell 2.5 pfennigs to DM1.4815.

The Bank of England was forced to offer special lending facilities to banks and building societies and the government securities market because Wednesday's support buying of the pound - estimated to have totalled pounds 10bn - had drained sterling from the financial system.

IMF warning, page 24