As a new survey shows falling business confidence, leading economic forecasters are calling on the Bank of England to lower Sterling's exchange rate.

The Ernst and Young Item club forecast is warning that action must be taken to prevent inflation undershooting the government's 1.5 per cent floor and the emergence of a two-tier economy.

The report says that while spending from both government and consumers was promoting growth, other sectors of the economy, especially manufacturing, were looking "very sick". It predicts the UK economy will expand by around two per cent this year, with growth picking up to 2.8 and 3.0 per cent in following years.

While the Bank has been cutting interest rates to keep the UK economy, the report rejects this approach. "We cannot see any sense in using interest rates to stimulate demand...when this would be better achieved through a lower exchange rate," it said.

The Item Club uses the same economic model as the Treasury to make its forecasts.

Professor Peter Spencer, economic adviser to the Item Club, said: "An official exchange rate intervention programme is vital to bring the economy and its external trade closer to balance. The time could not be better for the monetary policy committee to start talking down the pound, supporting the move by selling sterling in the exchange markets."

Reducing Sterling's exchange rate would help to re-balance the economy and enable the Bank to meet its inflation target, said Spencer. "A lower pound would help retarget inflation and transfer spending power from consumers to producers."

Sterling could drop by up to 10 per cent from its current level without inflation breaching the government's 2.5 per cent upper target in 2002.

The call for action came as a survey by the Institute of Directors showed business confidence falling to a three-year low at the end of last year.

The balance of companies saying they were more, rather than less, optimistic about future prospects dropped to 10 per cent in the last quarter of 2001. The figure had stood at 23 per cent last September.

However, there was more optimism when respondents were asked if their companies were performing well, with those reporting a positive performance falling slightly from a balance of 76 per cent in September to 72 per cent in December.