Pound slips on German rate worries

THE POUND drifted downwards to close below DM2.85 for the first time since the election yesterday as the markets waited nervously to see whether - and in what form - the Bundesbank would tighten monetary policy at its council meeting tomorrow.

'The market is caught like a rabbit in the headlights of a car,' said David Simmonds, economist at Midland Montagu.

He said market nervousness was compounded by producer prices figures showing that factory gate inflation in Britain was unchanged at 3.6 per cent in June, the lowest rate since August 1969. 'This shows there is no domestic impediment to lower interest rates,' he said.

Excluding food, drink and tobacco prices - which are affected by Budget changes in excise duties - output prices rose by a seasonally adjusted 0.5 per cent in June, five times May's rise. The annual rate of increase rose from 2.6 to 3 per cent. The Treasury said this was largely the result of exceptional falls in prices last year dropping out of the comparison.

The pound slipped steadily during the day, closing 0.31 pfennigs lower at DM2.8492. Sterling's jitters were not helped by unexpectedly weak factory output figures for May. These suggested that the fragile revival in manufacturing industry since the turn of the year had been extinguished, at least temporarily, by the continued stagnation of high street sales.

Manufacturing output fell by 0.6 per cent in May and April's small rise was revised to a 0.1 per cent fall. This followed two months of rises.

Evidence of renewed economic weakness is likely to intensify calls for the Government to devalue the pound in the exchange rate mechanism or to pull sterling out of the ERM altogether. If the Bundesbank tightens policy tomorrow this will only add to the pressure.

The 24-nation Organisation for Economic Co-operation and Development yesterday echoed Norman Lamont's view that there was no need for the Bundesbank to raise German interest rates.

It argued, in an authoritative review of the German economy, that pressure on inflation from a temporary surge in the amount of money circulating in the German economy was insufficient to demand tighter policy. Money supply growth has been boosted by the surge in subsidised credits to eastern Germany.

'But there should be no let-up in the pursuit of lower inflation, even if this means high interest rates for a prolonged period,' the OECD added.

It said that high government borrowing in Germany, largely to fund reunification, could prevent interest rates from falling. 'Determined measures are required to keep the underlying fiscal position under control,' it warned.

City economists believed a rise in the key German Lombard rate from its current 9.75 per cent was unlikely, but said that the Bundesbank could tighten policy more subtly. It might raise the discount rate, the floor for short- term market rates, from 8 per cent, or restrict the amount banks could borrow at the Lombard rate.

Fear of a Bundesbank tightening continued to inspire nervousness in the money market. The key market rate, which shadows City base rate expectations, remained an eighth of a percentage point above the current base rate of 10 per cent, suggesting the next move in British rates was more likely to be up than down.

The mark gained ground against the dollar as some profits were taken on the recent strength of the German currency. There were also no unpleasant surprises in the US economic data released yesterday. The dollar closed 0.85 pfennigs higher at DM1.4885, while the pound slipped 1.3 cents to dollars 1.9145.

Retail sales in the US rose by 0.5 per cent in June, largely because of higher car sales. This followed a 0.4 per cent increase in June. Excluding cars, sales rose 0.1 per cent in June following 0.2 per cent in May.

Consumer prices in the US rose by 0.3 per cent in June, following a 0.1 per cent rise in May. Higher energy costs were partly offset by lower clothing prices.

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