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Mervyn’s muddle

• Robert Peston
• 4 Sep 07, 09:30 AM

The has conspicuously and gamely resisted the temptation to follow the lead of the and by pumping cheap money into the London banking system in response to the collapse of confidence in credit markets.

It has stuck with its business-as-usual system that if a bank needs extra funds at the close of business for any reason, that bank can only borrow from the Bank of England’s emergency facilities at a one percentage point premium to the base rate.

But here’s the funny thing. The current base rate, which is supposed to be the reference point for the interest rates that affect all of us, is 5.75 per cent. But the benchmark commercial rate for lending between banks, three-month sterling , is 6.74 per cent.

Now in normal market conditions three-month LIBOR has typically been about 0.125 per cent higher than the base rate.

So what’s really striking is that three-month LIBOR has converged with the Bank’s emergency lending rate of 6.75 per cent.

Or to put it another way, that emergency lending rate has become the new reference point for the British economy.

And, in the current crazy market conditions, that’s a rational phenomenon.

Why? Because banks don’t want to lend to each other, or to other institutions, because they are not sure what’s under the bonnet of those borrowers (it’s the toxic fumes from sub-prime and CDOs that’s still putting them off).

In such circumstances, the benchmark interest rate for the economy has naturally become the emergency lending rate of the lender of last resort, the Bank of England.

And it will stay that way, unless and until banks somehow regain their poise and confidence – or the Bank of England provides copious additional loans at a lower rate.

So there is quite a risk that mortgage rates will rise and what businesses pay for finance will increase too.

But to state the bloomin’ obvious, the system is not supposed to work that way.

It is the base rate that is supposed to anchor the economy, not the emergency lending rate.

So the Bank of England has something of a dilemma.

It is rightly reluctant to slash interest rates and be seen to be bailing out all those negligent hedge funds and investment banks whose avarice precipitated the current crisis.

But it surely doesn’t want to penalise all of us, in the form of a sharp economic slowdown, just to teach those hedgies and bankers a lesson.

I don’t suppose Mervyn King, the Bank’s Governor, looks for divine intervention terribly often. He may require it this time.

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