Sterling has tumbled on the foreign exchange markets as UK manufacturing output fell a much steeper-than-expected 0.4 per cent in May, pointing to a third consecutive quarter of industrial recession.

As the opposition Conservatives criticised the British government's handling of the economy, sterling tumbled to DM2.968 - more than three pfennigs down against the German currency from Friday's close. As the British currency fell on international markets, the pound rose slightly to 84.57p from 84.06p on Friday.

Mr Jim Power, chief economist at Bank of Ireland, said the pound's small move back up yesterday was a "move in the right direction", but is not enough to be convinced that we will go all the way back up to 88p in the short term. "It is slightly reassuring and that is all," he said. "If the Bank of England does not raise rates this week, the speculation will simply recommence before the next meeting of the Monetary Policy Committee."

UK gilts and interest rate futures rose on the perception that the Bank of England would leave interest rates steady when it meets this week.

According to Mr Power, the reappraisal means that the markets now believe there is at best a 50:50 chance of another rate rise this week. "But it will remain well supported even if it does not breech its recent highs of DM3.10 again."

The latest data comes on top of considerable survey evidence that manufacturing output is slumping.

The British employers' group, the Institute of Directors, said in its quarterly business survey that confidence had suffered a "dramatic collapse" with orders and capacity utilisation tumbling and output growth slumping.

In addition, the Centre of Economics and Business Research warned of a return of the 1970s phenomenon of "`stagflation" - stagnating output with rising inflation.

The Office for National Statistics (ONS) said manufacturing output in May had not risen at all from its year-ago level. It also revised down April's 0.1 per cent rise to a 0.2 per cent fall.

The underlying growth trend for manufacturing is also negative - at minus 0.5 per cent - for the first time since 1992.

Economists said the data provided further evidence that the strength of sterling, high interest rates and weakening demand from Asia were taking a heavy toll on British manufacturers.

The booming service sector has been keeping the broader economy afloat in the teeth of manufacturing weakness, but Mr Adrian Schmidt, of Chase Investment Bank, said this might not be enough to stave off an outright recession for much longer.

The Bank of England, however, is still worried about runaway private sector earnings growth and its impact on inflation. This led to its key repo rate increase last month to 7.5 per cent from 7.25 per cent.