Pound on brink of free-fall: Heseltine would support raising of interest rates to stabilise sterling as fears of higher inflation are raised

THE POUND yesterday came dangerously close to free-fall as the erosion of confidence worsened and scepticism persisted over Norman Lamont's plans for a new economic strategy later this month.

Renewed attacks on sterling came as Michael Heseltine warned the Chancellor against allowing the pound to go into free-fall and staked out the ground for a battle over exchange rate policy which threatens to split the Cabinet.

The President of the Board of Trade said that Mr Lamont's policy of allowing the pound to float on the exchanges could lead to higher inflation, unless counter- measures were taken. Those could include deeper cuts in public spending, higher interest rates and higher taxation.

Mr Heseltine indicated he would support the Chancellor if he had to raise interest rates to stabilise the pound.

But he made clear the scope for tax increases was limited by the election manifesto, which put lower taxes and a promise to reduce the basic rate to 20p in the pound at the heart of economic strategy. 'That would have to be considered against the commitments the party has already made, and they are fairly comprehensive,' he said.

'The concern I have to have as President of the Board of Trade is that the industrial managers and work people realise the danger that would follow if we were to compound the falling of the pound with higher inflation at home,' he said in a BBC interview.

Asked about the pound going into free- fall, he said: 'Of course I am concerned about that because I know what dangers flow and how easy it is in the short-term to be deceived about what they perceive as the benign benefit. There are consequences and they are not all benign.'

At one stage sterling tumbled by almost 6 pfennigs yesterday as analysts warned that overseas investors appeared to have lost all confidence in the British currency. By the London close, however, sterling edged back slightly to close 4.66 pfennigs down, at DM2.4352 - still a record closing low. The slight recovery late yesterday afternoon was put down to normal caution before a weekend; the market expects selling to resume next week.

The Chancellor, off to Brighton for the Tory conference next week, faced renewed calls from Tory backbenchers to resign as Mr Heseltine lined up with other senior Cabinet ministers, including Douglas Hurd, the Foreign Secretary, and Kenneth Clarke, the Home Secretary, who want a more managed exchange rate.

Some Cabinet ministers, including Michael Howard, the Secretary of State for Environment, have emphasised that allowing the pound to float outside the exchange rate mechanism (ERM) offers opportunities.

Mr Heseltine said: 'One of the most serious risks is that people will respond to the euphoria of a more competitive pound - which is an opportunity for exporters - but we have seen consistently in the post-war world when we have these opportunities with floating pounds that we rapidly eroded it by increased levels of inflation usually associated with higher pay settlements . . .'

The battle over the exchange rate threatens to turn into a damaging Cabinet rift which will overshadow divisions on the Maastricht treaty, on which John Major has managed to unite the Cabinet.

Leading Tory opponents of Maastricht have said they would go along with it providing Britain remained out of the ERM. Mr Major would face open revolt if he attempted any early ERM return.

Indications that the Government would opt for stronger restraints on public spending in an attempt to shore up confidence failed to inspire the markets. Many analysts thought that was the wrong approach as long as the economy threatened to sink further into recession.

Moreover, hints from the Chancellor that he would base monetary policy on a series of indicators, for instance setting targets for the growth of broad and narrow money supply and paying attention to house prices, also failed to restore faith in sterling. Mr Lamont is due to expound his new policy in detail on 29 October.

In the meantime, Mr Heseltine and his colleagues are urging Mr Lamont to adopt a regime as tight as the disciplines which existed when Britain was a member of the ERM, implying more intervention to stop the pound sliding.

(Photograph omitted)