Sterling surges after Bank hints at rate rise

Sterling surged higher on the foreign exchanges last night after strong hints from the Bank of England that interest rates will need to rise further to keep inflation in check.

Dealers contrasted the Bank's hawkish stance with the relaxed approach to American borrowing costs taken by Alan Greenspan yesterday when the Federal Reserve chairman said he could afford to be patient.

With British interest rates already three percentage points higher than the 1% set by the Fed, the pound pushed through $1.88 on the foreign exchanges to its highest level against the dollar since late 1992.

Comments by Mr Greenspan that a weaker dollar would help tackle America's $500bn a year trade deficit also caused jitters in the market, putting upward pressure on the euro, the Japanese yen and the Swiss franc as well as sterling.

Nick Parsons, a currency analyst at Commerzbank in London, said: "There were 3,365 words in Greenspan's testimony, of which 289 were about the dollar. Not one of them said buy.

"Mr Greenspan was effectively saying that it's America's dollar and the rest of the world's problem."

The steady appreciation of sterling will add to the Bank's dilemma over interest rate policy. Earlier, the Bank of England's governor, Mervyn King, had said the Bank was expecting the economy to become better balanced over the coming years as exports and investment picked up, and consumer spending moderated.

The Bank admitted in yesterday's quarterly inflation report, however, that the level of sterling would be a crucial factor in determining whether its forecasts proved correct. "The higher level of sterling will offset part of the impact on inflation of faster domestic demand growth," Mr King said.

After its rapid ascent this week, sterling was already 2% higher than when the inflation report was completed earlier this month, with exporters to the US particularly hard hit by the pound's rise.

With consumer borrowing running at record levels, the City believes the Bank is nudging interest rates up in quarter-point stages for fear that more drastic action could lead to full-scale retrenchment. Some analysts believe, however, that the impact of monetary tightening is feeding through to exporters more quickly than to consumers, jeopardising the Bank's hopes of the economy becoming better balanced.

Mr King said it would take a hefty fall in house prices to return to the negative equity of the early-90s and dismissed allegations of reckless lending by mortgage providers.

The inflation report admitted that the Bank had been wrong in earlier forecasts of a slowing of consumer demand and a reduction to zero in property inflation.

"The committee may have underestimated the current momentum behind consumption growth and house price inflation, which could give rise to stronger activity in the near term and thus higher inflation.

"But that would increase the chance of a sharper correction to house price inflation and consumption growth at a later date," the report said.

Mr King said last week's increase in interest rates to 4% was justified, even though inflation as measured by the consumer prices index, at 1.3%, was well below the government's 2% target. Inflationary pressure in the pipeline would push the cost of living up to 2% within two years. Speculation in the markets of further rate rises this year was fuelled by Mr King's comment that inflation would still be rising by early 2006 and that the markets were anticipating more monetary tightening.

"Consumer borrowing and spending have been rising faster than expected, but are likely to slow in the face of decelerating income and house prices," the governor said.