City fears pressure from life in the ERM slow lane

RAPID moves towards a 'two-speed' Europe could limit Norman Lamont's ability to boost the British economy through lower interest rates, City economists fear.

A two-speed Europe would involve those members of the European exchange rate mechanism most closely linked to Germany accelerating their move towards a single currency, while other ERM members were left struggling until they satisfied tough entry criteria.

Alfons Verplaetse, president of the Belgian central bank, raised the stakes on Friday when he said that a five-country European single currency could start now with France, Germany, the Netherlands, Belgium and Luxembourg. The chances of a swift move to a mini-monetary union were also helped last week by the success - for now at least - of the Bundesbank and Banque de France in fending off a sustained attack on the franc.

An acceleration of the move to a single currency by the ERM's core nations would put considerable pressure on the British government to decide whether to return to the discipline of targeting its exchange rate or to 'go for growth' with lower interest rates, accepting the danger of higher inflation.

Mr Lamont has already been able to cut interest rates to 9 per cent now that he is no longer committed to keeping sterling above DM2.7780. The City expects another cut before next month's Conservative Party conference, and rates of around 8 per cent by the end of the year. But the Government has said it is not indifferent to the exchange rate, and City economists believe the Treasury will not be prepared to let the pound drop too far.

'Rate cuts will still have to be framed with half an eye on the currency,' said Ian Shepherdson, of Midland Montagu. 'And if there is a move for closer links within the German bloc, Britain will be seen as having a much more volatile currency.'

He added that if the Government did decide to cut interest rates aggressively, the pound could be in danger while British rates fell but German rates were unchanged. Moves to two-speed monetary union, with Britain in the second division, would only make things worse.

Kevin Gardiner, chief economist at Warburg Securities, said the Government could not afford to be indifferent to a falling pound, even outside the ERM. This meant the Government would have to take interest rate cuts slowly.' Most big post-war inflations have been the result of sharply falling exchange rates,' he said.

Mr Gardiner added that Mr Lamont's room for manoeuvre would also be limited by Britain's structural balance of payments problem, which is simply that Britain makes the wrong things at the wrong prices in the world market. 'It is interesting that Mr Lamont has not named the balance of payments deficit as one of the indicators he will look at in framing monetary policy. The trade figures will come back to haunt us,' he said.