Danger of 'demand shock' might lead to interest rates cut

A sudden collapse in consumer spending if households start acting to cut their immense debt bills could trigger a crisis in the financial system and force the Bank of England to cut interest rates, Sir Andrew Large, its deputy governor, indicated yesterday.

Sir Andrew said the Bank was "vigilant" over the levels of debt held by households and the Government and over the recent surge in the use of complex financial products such as derivatives.

"Servicing high levels of debt seems quite realistic. But a variety of things could get people to behave differently - to save more, or to repay debt," he told the City of London Central Banking Conference.

"This could come if they felt that interest rates might rise - and we did raise them modestly earlier this month. If a substantial change occurred it would, in the first instance, impact on monetary policy and our ability to meet our inflation targets."

Recent figures show that Britons are taking on a record amount of debt to fund the purchases of houses and high street goods. Any efforts to pay down their debt would probably feed through into lower spending, especially if rates rose rapidly.

Sir Andrew acknowledged that possibility, saying: "From a financial stability perspective too, however, we would clearly need to follow the evolution of any reactions and their consequences very closely."

He also warned of the need for vigilance concerning complex financial products such as derivatives - which allow companies to hedge against sudden movements in asset prices - used by companies to offset risk. "We certainly feel the need for vigilance. We need to understand the implications and threats of these instruments," he said.

Increasingly complex financial products mean it is hard to know where risks have been transferred from and who bears the risk, he said.

Sir Andrew also questioned whether companies understood the importance of using models to control their risk. He added that some contracts that had not been tested might not stand up in disputes between companies.