Pound's fall raises fears for interest rates

THE threat of a hike in British interest rates - raising mortgage costs and crippling any nascent economic recovery - looms large this week after the pound and the dollar plunged to new lows late on Friday.

Investors poured funds into the German mark in defiance of concerted attempts by the world's central banks to prop up sterling and the dollar. In late European trading and in New York the pound dropped below the psychological barrier of DM2.80 for the first time since Britain joined the exchange rate mechanism.

At one point the pound was barely 1.5 pfennigs above its floor in the system and nearly 16 pfennigs adrift of its central rate. If sterling threatened to fall through its floor of DM2.7780, the Bank of England would be forced to intervene in the currency market - or raise interest rates.

But five waves of intervention by 18 central banks - including the Bank of England - failed to halt the slide in the dollar and sterling on Friday afternoon. The pound ended the week in London at DM2.8028, while the dollar rose slightly from Thursday's close to end at DM1.4492. In New York it crumbled to a new all-time trading low of DM1.4325.

The falling dollar will be discussed at a meeting of senior officials from the Group of Seven leading industrial countries in the next few days.

Fears that British interest rates may have to be raised were reflected in the money market. The key market interest rate that tracks City base rate expectations rose by 1/8 of a percentage point to 10 3/8 , almost fully discounting a half-point rise in base rates from their present 10 per cent.

Economists expect the Bank to try to defend the pound through more vigorous intervention rather than raising rates - not least because higher rates may hurt the pound by pushing the economy deeper into recession. Gross domestic product figures released last week showed the economy was roughly flat between the first and second quarters, while a fall in July high street spending suggested a weak start to the third. Douglas McWilliams, economic adviser to the Confederation of British Industry, forecast that the economy would probably continue to shrink for a further four quarters even if interest rates were not increased.

On top of domestic economic gloom, sterling has been caught in the crossfire between the enfeebled dollar and the strong mark. The mark has been gaining at the dollar's expense because interest rates are nearly 7 percentage points higher in Germany than in the US. Fears that the Bundesbank might raise its key Lombard rate were not calmed last week by figures showing that the broad measure of German money supply rose at an annual rate of 8.6 per cent last month - well above the Bundesbank's target. If the Germans do raise rates, other European central banks - including the Bank of England - would almost certainly be forced to follow.

The financial markets also believe that the Federal Reserve may cut its interest rates in a further attempt to boost the US economy. 'Intervention will only provide a temporary floor for the dollar. The trend will not change until the interest differential with Germany starts to narrow,' said Nick Stamenkovic, economist at DKB International.

Further pressure on the pound may come this week from opinion polls in France, which show growing numbers of people intending to vote against the Maastricht treaty and a single currency in September's referendum. Analysts believe a 'no' vote would derail progress towards economic and monetary union, raise tensions in the ERM and cause a surge in the mark, triggering a realignment of the currencies.