Markets see interest rate rise as the first of several this year

Share prices fell and the pound rose yesterday as the financial markets bet on yesterday's increase in base rates from the Bank of England being the first of several this year.

Amid concern that tomorrow's meeting of G7 finance ministers and central bank governors in Florida will do nothing to halt the dollar's slide, sterling rose against the American currency after the monetary policy committee's noon decision.

Money market dealers believe UK rates will be nudged up gradually by the Bank so that they hit 5% by the end of the year, opening up a wide gulf with those in the eurozone and in the United States.

The European Central Bank yesterday left borrowing costs in the 12-nation eurozone unchanged at 2%, while the Federal Reserve is committed to keeping US rates at 1%, their lowest since the early 1960s, until it is sure that the American recovery is generating jobs and investment.

Some analysts believe the ECB will raise eurozone rates in the second half of this year, but more pessimistic commentators think that the rise in the euro will choke off Europe's exports and force the ECB to consider cutting rates.

The prospect of the two percentage point gap between UK and eurozone interest rates widening still further is expected to keep sterling underpinned against the euro, although it weakened slightly yesterday, losing a quarter of a cent to 68.5pagainst the euro.

Adrian Schmidt, a currency strategist at Royal Bank of Scotland, said: "Sterling looks OK because we will probably see another rate hike in May, and that could continue to support it against the euro."

Despite the underlying strength of UK demand cited by the MPC as a reason for raising rates, the stock market was unsettled by the possible impact of higher interest rates on Britain's borrowers. The FTSE index closed down 14.1 points at 4384.4 points, with the Engineering Employers' Federation warning that the appreciation of sterling would be bad for industry. "If higher rates translate into a strengthening of the pound, particularly against the dollar, this will take the steam out of any recovery in output and investment. Companies will hope this increase does not fuel further expectations of higher rates in the short term," said Steve Radley, the EEF's chief economist.

City analysyts last night said the pound was likely to remain strong. "Sterling will remain underpinned because of fundamentals and the interest rate argument, though the upside looks limited at the moment," said Mark Henry, a currency strategist at GNI in London.

The pound rose 0.6 cents against the dollar to $1.8419, within sight of its 11-year-high of $1.8577 reached last month. "If the G7 doesn't say anything about the weakness of the dollar and does not try to correct it then we could test $1.86, although I would be surprised if it broke [through]," Mr Henry said.