King flags up rate cut as he warns MPs of 'new phase' in credit crisis

The City was braced last night for an early cut in interest rates after the Bank of England said action was needed to protect the economy from a deepening credit crunch.

Mervyn King, the Bank's governor, said the financial crisis had entered a "new and different phase". Threadneedle Street was talking to the high-street banks to find a long-term solution. But, he warned, there could be no blank taxpayer's cheque.

King's remarks to the Commons Treasury committee came as the interbank cost of borrowing rose in the City for the 12th successive trading day. London interbank's offered rates for sterling funds lent over three months edged up from 5.995% on Tuesday to 6% yesterday, their highest since late December. Asked if the tighter lending conditions were making interest rate cuts more likely, King replied "yes".

Howard Archer, chief UK and European economist at Global Insight, said: "We now expect the Bank of England to trim interest rates by a further 25 basis points, to 5% in April rather than May. Further out, we expect interest rates to fall to 4.5% by the end of the year and to 4% in the first half of 2009, as we believe that extended below-trend growth will eventually significantly undermine companies' pricing power and limit wage growth, thereby diluting underlying inflation pressures."

Sterling also fell after the governor and four other members of the Bank's monetary policy committee gave evidence to MPs. Charlie Bean, Threadneedle.....continued below

Advertisement starts

Advertisement ends

Street's chief economist, said the size of Britain's current account deficit meant the risks to the pound were "on the downside" even after its recent decline. Another committee member, David Blanchflower, said he was concerned that "something horrible" could soon afflict the economy and said his concern explained why he favoured cheaper borrowing.

The governor said the MPC had to balance the risk that a sharper than expected slowdown in growth would lead to inflation undershooting its 2% target, against the possibility that a higher cost of living in the short term would become embedded and trigger a wage-price spiral.

Although the economy would slow down this year and next, it would be wrong to "confuse that with a depression or a slump", said King.

King added, however, that the housing market would stay in the doldrums for several years. "I would be surprised if in a few years' time house prices were markedly above where they are now. I see broadly stable house prices over the next few years." The two quarter-point cuts in bank rates in recent months had offset higher mortgage rates, he said, but "the heart of the problem is not in the real economy, it is in the financial sector itself".

Raising hopes in the City that the Bank might be prepared to consider more far-reaching support for institutions holding asset-backed securities, King said it was unrealistic to assume that markets for those investments worst hit by the credit crunch would reopen speedily or return to previous levels of activity.

Two principles would underlie any central bank role. "First, the risk of losses on their lending should remain with banks' shareholders; the banks neither need nor want the taxpayer to insure them against these losses. Second, a longer-term solution must focus on the overhang of assets and not subsidise issues of new assets."

guardian.co.uk © Guardian Newspapers Limited 2008