Market fears Bank of England has lost control of rates

By Edmund Conway
The Telegraph, London
Friday, December 7, 2007

http://www.telegraph.co.uk/money/main.jhtml;jsessionid=Q4TA5UE2GURWRQFIQ...

There were fears in the City last night that the Bank of England has lost control of monetary policy after expectations for money market borrowing costs rose -- despite the Monetary Policy Committee cutting interest rates.

Experts warned that it was a sign that the credit crisis could escalate over the Christmas period, even though the Bank has now embarked on a major series of interest rate cuts for the first time in almost eight years.

It coincided with a chilling warning from the Organisation for Economic Co-operation and Development that the UK economy is heading for a major slowdown next year -- and possibly a "significant slump" in house prices.

This month's short sterling futures, which indicate where the market expects the key benchmark interbank borrowing rate to be in two weeks' time, actually rose markedly after the Bank's decision -- an almost unprecedented reaction. The pound also ended the day up slightly on its trade-weighted index -- another highly unusual outcome on the day of an interest rate cut.

John Wraith of Royal Bank of Scotland said: "They haven't got the control over rates in the financial system that they ordinarily have.

"Historically, a 25-basis point change in Bank rate would lead to an almost identical change in Libor" -- the benchmark rate in the money market. "That hasn't happened."

He said this made it highly likely that the Bank would eventually be forced to cut rates even further than anticipated. A swathe of economists predicted borrowing costs could now drop to as low as 4.5 percent or below by the end of 2008.

Peter Spencer, chief economic adviser to the Ernst & Young Item Club, said: "The fact of the matter is that the market rather than the Bank is now dictating monetary policy -- and not from the point of view of controlling inflation, but from the point of view of a random walk. It is behaving in a way which is totally rational for individual banks but adds up to a major deflationary issue.

"I think this is a very grave situation indeed -- and not just for the 1.5 million" households due to renew their mortgages next year. "If this problem is not sorted out in the next two to three months, we are looking at major insolvencies in UK plc."

The sense of fear in the City was compounded by the severity of the Bank's brief accompanying statement, which said: "Conditions in financial markets have deteriorated and a tightening in the supply of credit to households and businesses is in train, posing downside risks to the outlook for both output and inflation further ahead."

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