AFTER heavy selling in the Far East overnight, sterling plumbed new

depths on European markets yesterday. Measured by its trade weighted

index it fell from 78.2% of its 1985 value on Friday night to 77.4, and

was at one point down at 76.7. By contrast share prices soared and the

FTSE-100 share index is now within 10 points of its all-time high.

The pound has lost nearly 16% of its international value since the end

of August. If the pound continues at these levels or if it falls

further, the devaluation will have been greater than the one in 1967.

The last time sterling hit an all-time low (77.8) on the foreign

exchange markets was November 12, the day of the Autumn Statement when

interest rates were cut from 8% to 7%.

Thereafter, it recovered well on the perception that the Government

intended to bide its time before considering fresh action after the

three 1% cuts in interest rates since the pound was ejected from

Europe's exchange rate mechanism.

That perception proved to be wide of the mark. Last week's further 1%

reduction, taking base rates down to a 15-year low of 6%, was widely

interpreted as a sign of panic in the Government's ranks.

In the City, there had been expectations that 1% would be lopped off

base rates at Budget time to compensate for the fact that the Chancellor

of the Exchequer was in no position to cut taxes and might even have to

raise them.

The week before last, disappointing retail sales figures for December

and an alarmingly sharp jump in unemployment for the same month

encouraged hopes of lower interest rates, but the cut came with

surprising speed and wrong-footed the markets.

City economists quickly assumed interest rates would still be cut by a

further 1% at Budget time, and a number even saw them falling

subsequently to 4% or even 3%.

The perception is that either the Chancellor or the Prime Minister (or

both) has decided to stimulate economic recovery at all costs,

regardless of the objective of confining underlying inflation, currently

3.7%, to its 1% to 4% target range.

In a weekend circular, Goldman Sachs's influential chief economist,

Gavyn Davies, one of the Treasury's panel of economic advisers, admitted

to being surprised by the timing of the latest cut in interest rates.

He went on to forecast that base rates would fall to 5% by the second

quarter of this year, and 4.5% by the end of the year. Nor would he be

surprised to see even lower interest rates by then.

Almost every independent economist believes that 6% is not the bottom

of the interest rate cycle. Into this cockpit of speculation, the Sunday

Times gave headlines to a story claiming that interest rates would fall

to 4% and that the Prime Minister had taken over the running of the

economy from Norman Lamont.

The report was denied by Downing Street, but it had too much of the

ring of truth about it not to influence trading on foreign exchange

markets. In the event, the effect was quite dramatic.

Sterling fell to an all-time low of DM2.3550 in overnight trading. It

later recovered some of this loss, but still ended the day about

one-and-a-quarter pfennings below its Friday night level at DM2.3760. In

fact, the big fall occurred against the dollar where sterling lost over

three cents to $1.4550.

Gavin Davies concedes that the most likely risk to his own forecast of

even lower interest rates is a collapse in sterling, forcing the

Government to raise base rates to defend the pound.

But he reckons that a European recession and developing weakness in

the Deutschmark and other European currencies will avert a sterling

crisis. Instead, he expects ''an orderly, though quite large, decline in

sterling with particularly large falls against the dollar and the yen.

Other economists are not sure. In yesterday's Herald, we recorded the

fear of National Westminster's chief economist, David Kern, that by next

year interest rates will be back up to 7.5%.

In another weekend circular, economists at James Capel specifically

asked if 6% was sustainable. Keith Skeoch and Adam Cole argued that a

further devaluation of the exchange rate could help foster revival in

the second half of the year.

But they expressed grave doubts that rates of 6% or less could be

sustained for more than a few months at the most. The Capel economists

claim the move to 6% base rates has opened up the largest interest-rate

differential with Germany since 1973.

Over the last 20 years, the UK has never been able to maintain such a

large differential for longer than a couple of months. ''The exception

was in the early 1970s, which laid the foundations for the Barber

boom.'' With the final twist being delivered by the hike in oil prices,

that resulted in UK inflation of 25% for more than a year.

In contrast to the sorry state of sterling on the foreign exchange

markets, shares celebrated the latest turn of events. International

stocks, like BAT Industries, were to the fore. Their overseas earnings

are worth more in sterling the further the pound drops. The Footsie

jumped 44.4 points to 2851.6.

Lower interest rates are of direct benefit to business and encourage

hopes that the recovery, as yet still born, may eventually build up to a

decent pace. The stock market does not mind a bit of inflation either as

it devalues corporate debt piles.

There was no major rights issue yesterday to upset the applecart. At

current levels, the stock market is vulnerable to a further rash of

these. It may also have second thoughts at the patchy nature of any

recovery evidence which will at best emerge in the next few months. The

biggest blow, however, would be a sterling crisis, forcing the

Government to do a U-turn on interest rates, before any recovery is

firmly established.