CURRENCIES

The pound is expected to extend last week's five pfennig gain against the deutschmark on speculation that inflation is accelerating fast enough to warrant higher interest rates.

Evidence of strong consumer demand and surging inflation last week provoked an about-face in interest-rate expectations. Eight of 16 economists surveyed expect the Bank of England will raise interest rates as soon as next month, compared with two weeks ago when only two out of 21 were forecasting an increase.

"All the data this week points to the fact that the latest quarter-point increase probably won't be the final increase," said Paul Chertkow, head of global currency research at Bank of Tokyo-Mitsubishi.

"Given this speculation, the pound's gains could prove stratospheric," possibly topping the nine-year high of 3.1102 marks set in March.

The pound rose as high as 3.0057 marks on Friday, its strongest since 1 May, and to $1.6745 against the dollar, a high since 30 April.

Interest rates are already at a five-and-a-half-year high of 7.50 per cent. Higher rates provide a better money-market return, making the pound more attractive to investors.

Three-month sterling deposits, for example, bring 7.81 per cent while mark deposits bring 3.56 per cent and dollar deposits 5.68 per cent.

The pound has been rising since Tuesday, when the Government reported that retail price inflation was accelerating at an annual pace of 3.2 per cent, prompting Bank of England Governor Eddie George to say the economy is "as close to overheating as it has been in a long time". At the end of last week, he said inflation would continue to accelerate faster than the 2.5 per cent target set by the Government.

Furthermore, underlying average earnings rose by an annual 5.20 per cent in March, up from 4.90 per cent the previous month, and retail sales rose 1.7 per cent in the month to May after falling by a revised 0.2 per cent in April.

Economists expect a report on Tuesday to confirm that gross domestic product grew at 2.9 per cent in the first quarter, unchanged from the fourth quarter last year.

Sterling interest-rate futures make plain the shift in rate expectations. The yield on the September contract is 7.95 per cent, a wide enough gap with the official interest rates to signal to investors that they should expect at least a quarter-point rate increase by September.

"We've seen a major shift in interest rate expectations over the last month to six weeks," said Adrian Cunningham, the director of economics at Scottish Mutual Portfolio Managers.

The pound has risen 27 per cent against a trade-weighted index in the past two years, gains that are hurting exporters. Mr Cunningham said, however, that exporters could see some relief next quarter. "The degree of monetary tightening priced into the market is overdone," he said.

"We're going to see further signs that the economy is slowing as we move into the third and fourth quarter, and that will take some of the upward pressure off the pound" and knock it to 2.90 marks by the end of the third quarter.

Copyright: IOS & Bloomberg