Pound reaches highest point for two years

The pound surged yesterday to its highest level for nearly two years, propelled by expectations that a booming economy will mean higher interest rates and by post-Tory conference euphoria.

As John Major pledged to cut taxes and increase health spending, the pound climbed above DM2.41 for the first time since January 1995. It ended the day nearly two pfennigs higher at DM2.4124, and its index against a range of currencies added 0.6 points to reach 87.8.

The financial markets are now betting that base rates will increase before the likely election date, following disappointing inflation figures on Thursday. Indeed, futures prices point to a quarter-point rise in interest rates to 6 per cent before the new year and a further rise to 6.5 per cent by next summer.

The change of view about interest rate policy reflects the mounting evidence that the pace of growth is picking up. Minutes of last month's meeting between Eddie George, Governor of the Bank of England, and Kenneth Clarke, Chancellor of the Exchequer, published this week revealed that the Bank thinks there is a "significant risk" of missing the inflation target if the Chancellor does not tighten monetary policy.

Official figures on Thursday showed that the underlying inflation rate increased last month. It was 2.9 per cent in September, up from 2.8 per cent, compared with the 2.5 per cent target.

The political mood also helped to propel the pound upwards yesterday. Traders said that overseas investors seemed to like the outcome of the Conservative Party conference.

Chris Turner, currency strategist at BZW, said: "There has been a fair amount of overseas interest in sterling since Tony Blair visited the US. That makes it a bit surprising that investors reacted well to the Tories this week, but they did."

He warned that investor sentiment might shift back the other way, especially if the financial markets also conclude that their interest rate expectations are overdone.

Figures on US inflation and retail sales yesterday suggested there would be no pressure on the Federal Reserve to change interest rates on the other side of the Atlantic.

Prices charged by manufacturers at the factory gate rose 0.2 per cent last month to a level 2.9 per cent higher than a year earlier. This was lower than the previous month and less than analysts had expected.

"Core" producer prices, excluding the volatile food and energy components, have risen only 1.4 per cent during the past 12 months. Higher energy and gasoline prices, reflecting the higher price of crude oil, explained the difference between the core and headline rates.

There was a big increase in retail sales in September. But the impact of the 0.7 per cent rise was offset by a big downward revision to the August sales figure. The Commerce Department changed its initial estimate of a 0.2 per cent increase to a 0.2 per cent drop instead.