Inflation fall breathes some life into sterling

THE POUND recovered from an all-time trading low yesterday as the Chancellor of the Exchequer and the incoming Governor of the Bank of England ruled out for now another cut in interest rates and inflation fell to a 25-year low.

The unexpectedly sharp fall in inflation to 1.7 per cent in January put the gilts market in euphoric mood but received a mixed reaction in the currency markets.

Gilts jumped sharply on the news. 'There was five seconds of disbelief and then it was frantic,' said Ian Shepherdson, of Midland Global Markets.

Short-dated prices rose on the belief that a key obstacle to lower interest rates had been removed, while the long end rose on optimism that inflation would stay under control for some time.

The price of the 8 3/4 per cent 2017 government bond, a benchmark long gilt, rose by 2 1/4 points to 10022 32 . Gilts prices also received a late boost when the Bank of England issued pounds 800m of new stock, less than expected.

The currency markets were at first uncertain how to react to the fall in inflation. It increased the markets' conviction that interest rates would fall again, but the sharp rise in gilts prices pointed to higher demand for sterling. 'The market was torn both ways,' said Alison Cottrell, of Midland Global Markets.

In Tokyo and early London trading the pound had fallen below DM2.33 for the first time. Against a basket of currencies sterling opened 0.3 points lower at 75.7 per cent of its 1985 value.

But after the inflation figures were announced the Chancellor, Norman Lamont, said: 'I don't normally comment on interest rates but there has been so much speculation I have made it clear today that on the available evidence I do not see scope for further reductions in interest rates.'

The pound then rose, hitting DM2.36. The Bank of England was reported by some dealers to be selling small amounts of sterling at these levels. Sterling closed at 76.2 per cent of its 1985 value against the basket of currencies, up 0.2 points on the day. The pound ended 0.65 pfennigs higher at DM2.3575 and barely changed against the dollar.

Speaking in Frankfurt, Eddie George, incoming Governor of the Bank of England, backed the Chancellor's view on interest rates. He said: 'The scope for a further decline in our interest rate is very limited,' and added: 'If a further fall in the exchange rate were threatening our inflation strategy, the Government would have to respond by tightening policy.'

Mr George also made his clearest statement to date in support of making the Bank of England independent. 'If the Government and Parliament said the Bank of England will be independent tomorrow, this would help the credibility of policy and would help the pound,' he said.

Even though it is generally expected that German interest rates will drop in the coming months as the deep recession pulls inflation back down again, Mr George emphasised: 'There can be no question of Britain anticipating what might happen in Germany.'

He added: 'It would be wrong to assume that if German rates fell it necessarily follows at all we would do similarly.'