City gambles on imminent rise in interest rates: Markets thrown into turmoil by speculation that next week could see first increase in base rates since 1992 ERM crisis

MILLIONS of mortgage holders and businesses could be paying higher interest rates as early as next week, after speculation ran riot in the City yesterday that the Bank of England was planning an imminent rise in base rates.

Panic broke out in the financial markets yesterday afternoon, after the Bank said it was prepared to pay much higher interest rates than a week ago to people who lent money to the Government. This followed a leaked survey from the Chartered Institute of Purchasing and Supply (Cips), showing a dramatic strengthening in upward pressure on factory gate inflation.

The markets were thrown into confusion as economists tried to work out whether the Bank was attempting to prepare them for a rate rise next week, or whether it was merely reflecting fears of a rate rise that had been mounting in the markets over the past few days. The Treasury and the Bank refused to comment on the move, but both were criticised by City economists for their handling of the day's events.

The short-sterling futures market, in which City dealers gamble on the future level of interest rates, plunged in frantic trading. By the end of the day it forecast that base rates may rise to more than 6 per cent by September from their current 5.25 per cent. The market also signalled base rates of nearly 6.75 per cent by the end of the year, although most economists believe that is too pessimistic.

'The Bank of England's operations are bizarre and inexplicable unless interest rates are rising next week,' said Steven Bell, an economist at Morgan Grenfell. A rise in base rates would be the first since Norman Lamont's doomed attempt to keep the pound in the European exchange rate mechanism on Black Wednesday in 1992. The last rise before then was in 1989.

Simon Briscoe, at Warburg Securities, said it looked as though interest rates would rise on Monday or Tuesday next week. But he added that the Bank had lost its chance to appear decisive and foresighted in raising rates. Instead, it would look as though it had been pushed into a corner.

The prospect of higher interest rates pushed the pound more than two pfennigs higher against the mark and drove share prices down.

However, David Walton, of Goldman Sachs, said the markets had suffered a 'collective loss of nerve' and that an early interest rate rise was unlikely.

The City had already been in a nervous mood because Eddie George, the Governor of the Bank of England, and Kenneth Clarke, the Chancellor of the Exchequer, had met at the Treasury on Thursday to discuss possible changes in interest rates. The Chancellor decides whether rates should change, but the Bank is free to choose the timing, or criticise the decision. City dealers predict that a rate rise might be timed to coincide with the publication of the Bank's quarterly report on anti-inflation policy, due on Tuesday.

The Governor believes that interest rates should be raised pre- emptively, before a rise in inflation has a chance to become entrenched. But the Chancellor is more cautious, preferring to see clearer evidence that price increases can be made to stick.

The Government's target measure of underlying inflation - which excludes the impact of mortgage interest payments - stood at 2.4 per cent last month, its lowest for a generation. But economists worry that the unexpectedly rapid pace of economic recovery is fuelling a future pick-up in inflation. The Cips survey suggested that manufacturers' prices were being pushed sharply higher by rising packaging and steel prices.

Roger Bootle, chief economist at Midland Bank, said he saw no justification for a rise in rates, because underlying inflation was set to remain well within the Government's 1-to-4 per cent target. But he said that 'many people in the market now have no scintilla of doubt that rates are going to rise on Monday'. He added that the Bank had lost credibility by failing to calm the market chaos.

The Bank had borrowed money on the Government's behalf by selling Treasury bills at interest rates of up to 5.75 per cent. Last week it had borrowed at less than 5 per cent. On previous occasions the Bank has been prepared to cancel Treasury bill tenders if they might send the wrong signal.