Inflation: Effect of a rate rise on. . .Institutions in the City

BECAUSE the City prides itself on its ability to spot trends, much of the likely damage from higher inflation or interest rates has already been built into the prices of securities, writes William Kay.

That is why the gilts market has been savaged. And some of the worst performers on the stock market this year have been in the financial sector - the shares of banks and insurance companies have fallen by as much as 30 per cent.

Until the rally at the end of last week, National Westminster Bank had fallen from 622p to 421p, Lloyds from 660p to 530p, SG Warburg from 1,012p to 679p and the Prudential from 385p to 271p.

'In my view, interest rates are in any case unrealistically low,' said David Poutney, banking analyst at the stockbrokers Collins Stewart. 'If anything, the banks are suffering from low interest rates because they have the use of a lot of free capital - in current accounts and so on - and they are not getting a good return on that.'

Mark Eady, banking analyst at NatWest, added: 'Banks struggle when interest rates are either very high or very low, but they are comfortable between 5 per cent and 10 per cent. We think the falls in bank shares have been overdone.'

The fall in insurance company shares has been only partly caused by the wider economic environment, and then largely because the insurers are big holders of other shares at a time when the market has been falling. They have also been troubled by regulatory concerns and the public's switch from endowment policies to personal equity plans and unit trusts, which do not carry as much profit for the providers. Rising interest rates might encourage savers to switch out of these vehicles into gilts or interest-bearing deposits.

The most corrosive effect of higher inflation and interest rates is uncertainty, which scares investors away from making commitments, so cutting the commission and fee income on which many City firms rely. And the outlook this weekend is still gloomy.