The City believes it is unlikely that the Government will put the pound back into the ERM in the near future - and perhaps not at all. In that case, high interest rates would not be required to maintain a strong pound, suggesting that cuts may be possible. Reductions might also be made easier by further falls in German interest rates if there was another realignment of ERM currencies.
Economists believe base rates could well be down to 8 per cent by the end of the year from their current 10 per cent. 'It is very likely that we will see a rate cut before long, especially with the Conservative Party conference next month,' David Walton, economist at City firm Goldman Sachs, said.
The stock market reacted enthusiastically to this prospect. The FT-SE 100 index rose by 83.1 points to 2,567, an increase of almost 200 points in two days.
The pound dropped towards DM2.60 during the morning, but bounced upwards when Norman Lamont, the Chancellor, gave an interview in which he said the Government was following a 'British economic policy' and cast doubts on the speed with which the pound would rejoin the ERM.
Hopes of the rate cuts were reflected in the prices offered by investors buying pounds for future delivery. These short sterling futures suggested cuts of around 1.5 points by the end of the year. The key three-month interbank lending rate - which tracks City base rate expectations - also suggested that the next move in rates was down, falling below the current base rate to 9 5 8 per cent.
The pound reacted favourably to the prospect of lower rates, with the perceived beneficial effect to the economy seen as outweighing the lower return it would imply on sterling investments.
However, the pound drifted down during the rest of the day and ended at DM2.6106, down 1.73 pfennigs on Thursday's close. But analysts said the pound could drop below DM2.60 if a 'no' vote in Sunday's French referendum on the Maastricht treaty prompted the demise of what remained of the ERM.
The pound is now almost 34 pfennigs below its former central rate in the ERM of DM2.95, amounting to an effective devaluation of more than 11 per cent.
The pound continued to fall against the dollar, which was enjoying safe-haven status for investors wishing to flee the turmoil of the European currencies. The pound fell by 4.7 cents to dollars 1.7430 - only 10 days ago it was worth dollars 2. The dollar also gained against the mark, rising by 1.55 pfennigs to DM1.4970. The US currency was helped by the belief that interest rates are going to fall in Europe, narrowing the advantage over the lower rates offered in the US.
The strains among the surviving currencies of the ERM continued to mount ahead of Sunday's vote. The Bank of France mounted another support buying operation for the franc, helped by comments from Hans Tietmeyer, the Bundesbank vice-president, that the franc was a 'candidate for revaluation' in any ERM realignment. The Irish punt and Portuguese escudo also came under pressure.