Sterling fell below 2.90 deutschmarks for the first time since early this year after the Bank of England predicted the British government's inflation target would be realised in two years time, indicating no need for further rises in UK interest rates. Sterling also closed marginally down against the pound at 86.75p.
At the same time, though, the Bank warned of the inflationary danger of a "more rapid fall" in sterling in coming months in response to changes in UK economic prospects compared with other countries, notably "euro-land".
The British currency fell 1.40 pfennigs to DM2.8905 and the break below DM2.90 prompted currency chartists to pinpoint DM2.84 as the next support level.
The Bank of England is concerned about the fragility of sterling. It warned in its "Inflation Report" yesterday that "a substantial fall in sterling is more likely than a substantial rise". The bank's medium-term inflation projections are based on the assumption of a decline in sterling to DM2.78 in two years time as part of a 3 per cent reduction in the British currency's value measured against a "basket" of world currencies.
Although its inflation predictions would be affected by a larger decline in sterling, the bank's economics team is now more confident than three months ago that the government's target of 2.5 per cent "core" inflation excluding mortgage interest costs will be achieved on schedule in two years time.
The main risk to achievement of the inflation target is "the possibility of a more rapid fall in the exchange rate" than expected in coming months. Support for the bank's more sanguine view on inflation prospects came from official figures showing a sharp deceleration in the rate of pay rises during the spring from 5.4 to 5.0 per cent, well below City expectations.
Fears of inflationary pay settlements were the main factor prompting the bank's Monetary Policy Committee to lift UK interest rates to 7.5 per cent in June. If the rate of pay rises continues to subside, the conditions may be created for the first reductions in interest rates later this year, particularly if economic growth falters.
But there are mixed signals about a growth slowdown. Although manufacturers are warning of imminent recession, the labour market is continuing to tighten. Official figures yesterday showed that the number of people claiming unemployment benefit fell by 26,000 to 1,335,100 last month, the lowest number for nearly 20 years. Also, the number of out of work including those not claiming benefit fell by 62,000 to 1,802,000, the lowest total since the more embracing definition of joblessness was introduced in 1984.
City economists believe the bank will refrain from starting the decline in UK interest rates until the unemployment figures begin to deteriorate later this year or early next year.
