Falling sterling eases pressure on pound and interest rates

SHARP fall in the value of sterling has alleviated fears of further pressure on the pound in the currency markets. Meanwhile, the latest domestic inflation data show no sign of a pick up in price pressures and should also ease fears about further upward pressure on interest rates.

While this week's interest rate rise demonstrated the Central Bank's concern about how the recent weakness of the pound would affect inflation, figures out yesterday showed that inflation remained subdued in April, rising by just 0.1 per cent in the month.

And in a turnaround from recent trends, movements in the foreign exchange markets yesterday eased the dilemma the Government and the Central Bank have been facing.

The long awaited decline in sterling was prompted by reports that the new Labour government and its Chancellor of the Exchequer, Mr Gordon Brown, were considering entering the EU single currency and at a much lower rate than it is currently trading against the deutschmark.

The British treasury moved quickly to deny the story but traders remained concerned that it may indicate that Mr Brown and other members of the British government are worried about the strength of the currency.

As a result, sterling fell four pfennigs against the Dmark, prompting the pound to rise above 93p and to fall against the Dmark.

In late trading, it closed at 93.25p against sterling from 92.31p and at DM2.5737 from DM2.5981 a day earlier.

A fall in the dollar also dragged sterling down after comments from Japanese and German officials that the dollar was too high.

The move allowed traders to push the pound down against the deutschmark without it falling against sterling, reversing the problems of last week when downward pressure on the pound against the deutschmark also moved us down against sterling.

If the move is sustained, it will ease pressure on the Central Bank, and remove fears of further upward pressure on interest rates.

According to the Bank, the main reason inflation has been subdued is that the trade weighted exchange rate has appreciated sharply. The Bank now fears that a falling trade weighted exchange rate could import inflationary pressures. As a result the Bank last week raised its short term facility by half a percentage point, prompting similar rises in mortgage rates.

Yesterday, First National raised its variable mortgage rate by a half point, while Bank of Ireland put its up by 0.4 of a point in line with rises from the TSB. These rises follow announcements from Irish Permanent and AIB earlier in the week.

The mortgage rate rises are likely to add 0.1 per cent on to the headline inflation rate. However, there will be no impact on the EU measure, which excludes all housing costs.

There is still considerable uncertainty about the future of sterling. Mr Jim O'Leary, chief economist at Davy Stockbrokers, pointed out that Labour had promised to hold a referendum on the single currency in Britain and that a majority of the British public was against the idea, according to the most recent opinion polls.

However, be added, it was likely that sterling at DM2.80 was at the top of its cycle. Sterling was also underpinned by expectations that interest rates would rise by at least another one percentage point over the next year. "It is likely to fall if those expectations are not realised," he said.

But, as Mr O'Leary noted, now that Mr Brown has ceded control of raising rates to the Bank of England, it makes interest rate rises more likely than they would otherwise have been.

Mr Avinash Persaud, head of global foreign exchange research at J P Morgan, said he was expecting sterling to fall in the run up to Mr Brown's mini Budget in July.

According to Mr Persaud, sterling may lose some of its EMU safe haven status. In addition, it is vulnerable because of the size of its over valuation and the prospect of fiscal rather than monetary tightening.

He is expecting sterling to fall to between DM2.68 and DM2.71. "If the budget reveals less fiscal tightening than anticipated, sterling will recover," he said. "But before that, the direction is down and volatility will remain high," he warned.

Meanwhile, the Confederation of British Industry distributive trades survey showed that retail sales growth in April was the highest since November 1996. Some dealers took heart from this, pointing out that more high street spending leads to higher inflation and hence higher interest rates.