HEADING FOR THE ROCKS – The Fed’s Kohn warns of ‘uncharted waters’

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The Bank of England is warning that high street banks face big new risks from future rises in interest rates and the current crisis in the bond markets.

City analysts are concerned that the Greek crisis – the need to finance a huge budget deficit – will lead to upheavals in the bond markets, and much higher interest rates.

The Bank’s nine-member Monetary Policy Committee (MPC) is meeting this Thursday to set interest rates and to decide on whether to halt its £200bn programme of quantitative easing (QE), or extend it.

This follows remarks from US Federal Reserve vice-chairman Donald Kohn that ‘We are in uncharted waters for monetary policy and the financial markets.’

In a speech to bankers at the Federal Deposit Insurance Corp., Kohn warned of a rising budget deficit, foreign demand for US debt and the strength of the recovery.

He said: ‘Many banks, thrifts and credit unions may be exposed to an eventual increase in short-term interest rates.’

Responding to Kohn’s remarks, Bank of England deputy governor Paul Tucker has admitted that UK authorities should consider this prospect including rapidly rising inflation.

Tucker told MPs on the House of Commons Treasury select committee last Tuesday that the US alert to banks had been discussed recently at a central bankers’ forum in Basel, Switzerland.

The Treasury committee heard both Tucker and Bank of England governor Mervyn King discuss the potential problems associated with withdrawing the series of stimulus packages put in place to bail out the banks and reinvigorate the economy.

Meanwhile, Andrew Sentance, a leading member of the MPC, also hinted last week that the bank is concerned about a looming inflation threat.

Addressing a conference of the British Property Federation, Sentance said that the Bank faces some tough choices as the economy faces a battle of opposing forces.

He claimed there was cause for optimism on growth, but warned ‘therefore’ of ‘a danger of price pressures – because sterling was at a more competitive level than during the last recovery in the mid-1990s and manufacturers were more optimistic in business surveys.’

He added: ‘If the tailwind from the global economy, a competitive exchange rate and a recovery in confidence are felt more strongly, then the margin of spare capacity could be eroded more quickly. In that scenario, there will be more upward pressure on inflation.’

On the other hand: ‘If the headwinds from the financial crisis and the consolidation of public finances dominate the outlook, the balance of risks to inflation are likely to be to the downside.’

Bourgeois analysts are predicting the MPC will be split on whether to extend the controversial £200 billion quantitative easing, or ‘creating’ money, programme.

On Saturday, IMF head Dominique Strauss-Kahn warned against governments ending stimulus programmes too soon.