Commentary: Stiff upper lip time for sickly pound

The currency markets have no intention of allowing Norman Lamont to enjoy his pre-Budget purdah. With the pound matching its all-time low on the trade-weighted exchange rate index, there will be some wailing and gnashing of teeth in Treasury chambers.

Sterling is more than 16 per cent below its level just before it left the exchange rate mechanism in September, and that is quite enough of a devaluation for even a recession-raddled economy to absorb.

The Chancellor, though, has little option but to grin and bear it. Any premature rise in interest rates risks sending the pound down, rather than up, on the view that it would postpone a recovery, make UK assets look overpriced and unattractive and hold out the prospect of fewer interest rate rises.

Market economists are talking about rates of dollars 1.35 and DM2.20. When the pound looks ridiculously underpriced, it will be easier to bend the trend back.

The proximate cause of sterling's weakness yesterday was the dawning realisation that the Bundesbank council is composed of some extremely stubborn men who mean what they say about wanting 2 per cent inflation. Yesterday's partial inflation numbers from the lander suggested that January's 4.4 per cent figure was no freak. The more slowly infla

tion subsides, the less rapid is likely to be the easing in interest rates - and the greater the risk of mark strength.

The pound is likely to be one victim, but the other could be the French franc. It has been hovering nervously a little above its ERM floor. As the two rounds of French elections approach on 21 and 28 March there may be a re-run of the accelerator phenomenon which pushed sterling and the lira out of the ERM.

If speculators believe that there is a 10 per cent chance of a 10 per cent devaluation at some indefinite point in the future, they might normally require an interest rate of one percentage point higher than that available on marks to persuade them to hold francs.

But if they know that the risk of a devaluation attaches to one specific day, there is a new and far more severe problem. As the day approaches, the one-percentage-point gap in interest payments has to be steadily compressed over a shorter and shorter time. The day before the likely date, the difference has to be hundreds of per cent expressed as an annual rate if the speculator is to be persuaded to hold francs not marks.

The French and the Germans may bluff their way out of trouble. They may adopt extreme measures such as open- ended intervention - printing marks - by the Bundesbank. But the credibility of the ERM is now much diminished after the travails of the autumn, and the markets are in playful mood.