Sterling in meltdown as rates are frozen

Sterling fell to its lowest level against the euro yesterday after a nervous Bank of England shrugged off pleas from industry and kept rates unchanged at 3.75%.

Caught between a resurgent euro and a faltering dollar, the pound hit six-year lows against a basket of world currencies for the second day in a row, and fell to record low of 71.87p against the single currency.

City analysts said the sharp slide in sterling since the beginning of the year had been the decisive factor in the monetary policy committee's decision. Sterling has dropped by almost 5% in trade-weighted terms since February and at last month's meeting the MPC warned its fall could stoke inflation by up to 1% next year.

Business leaders said the MPC had missed a chance to bolster confidence and would be forced to cut rates again to prevent output stagnating.

"The timing of this decision is out of line with most of the evidence showing the economy weakening further," said Martin Temple, director general of the Engineering Employers' Federation. "As evidence mounts of the dire state of our markets in the eurozone, the Bank will be under growing pressure to cut rates if we are to see any prospect of reasonable growth this year."

In a double blow to exporters, the European Central Bank voted to keep interest rates in some of Britain's most important markets on hold. Ignoring pleas from German politicians and trade unionists to cut rates to boost economic growth, the ECB kept them unchanged at 2.5%.

ECB president Wim Duisenberg said inflation was not falling as rapidly as expected, which meant the bank had decided "to still wait a while".

Currency analyst Nick Parsons at Commerzbank in London said the ECB had had the perfect opportunity to reduce borrowing costs. "With growth slowing and the currency appreciating it is hard to see a better background against which to cut rates."

There was some consolation for industry leaders when Mr Duisenberg announced a shake-up of the ECB's controversial inflation ceiling of 2%. Critics have charged the Frankfurt-based bank with being obsessed with the danger of inflation and ignoring the risk of deflation.

In a statement, the ECB's governing council said it would stick to the 2% ceiling as its definition of price stability, but would "aim to maintain inflation rates close to 2% over the medium term".

Mr Parsons said the changes indicated the ECB was "coming more into line with the Bank of England and the Federal Reserve, and moving further away from the old Bundesbank approach."

The euro put on a new show of strength after the ECB's decision, hitting a four-year high against the dollar of over $1.15.

City analysts expect the slide in sterling to boost the Bank of England's estimates for growth and inflation when it releases its latest forecasts next week.

"Today's decision to leave interest rates unchanged presumably reflected a belief amongst MPC members that the drop in the exchange rate will do their job for them," said Jonathan Loynes, chief UK economist at Capital Economics.

Industry leaders said the fall in the currency would not be enough to offset worrying signs of faltering demand in home markets.

"The Baghdad bounce in the financial markets has yet to have a significant effect on the real economy and there are worrying signs of domestic weakness in retailing, housing and consumer services," Ian McCafferty, CBI chief economic adviser, said. "The recent fall in sterling is unlikely to pose a significant risk of higher inflation, given the degree of excess capacity and the weakness of demand."