Who controls interest rates? Where will my mortgage rate go?

In recent months interest rates have been cut by the Bank of England, but borrowers are complaining the falls are not being passed through to their mortgages.

So who controls interest rates in the UK?

When Labour came to power in 1997 the Bank of England was given independence to set UK interest rates with a target of two per cent for CPI inflation. This took the power to raise and lower the cost of borrowing out of the hands of politicians and for most of the last ten years lenders have followed the lead of the Bank of England.

However, the credit crunch that hit last year revealed the relationship between the banks, the Bank of England and the money markets is far more complex.

Bank and building societies at the end of the day are commercially free to set interest rates as high or low as they please – as we can see with Northern Rock setting rates above the market averages in a bid to reduce its mortgage business.

Traditionally the banking model – still followed largely by building societies – is for firms to lend from cash raised from savers. But Northern Rock got stung as it was also borrowing cash to lend from the money markets.

On the money markets – which seized up and meant Northern Rock had to turn to the Bank of England with disastrous consequences – interest rates are not set by Bank but are seen in the London Inter-Bank Offered Rate – or Libor.

Libor measures the interest rates banks lend funds to each other on the wholesale money markets.

Generally Libor rates follow the Bank of England base rate – or repo rate – and when interest rates are expected to fall interbank rates are generally below the Bank's.

Currently the money markets are showing the Libor is above the repo and the markets are taking control of rates consumers find at the end of the line when getting a mortgage, new analysis from Capital Economics shows.

"The recent renewed rise in interbank lending rates is an unwelcome development which means the MPC will have to work harder to support economic activity," said Paul Dales, UK economist at Capital Economics

"This supports our view interest rates will eventually fall further than the markets or most other forecasters expect."

In order to keep interbank rates down, it is predicted the Bank – and other central banks – will have to pump more cash into the money market.

Mr Dales said: "Recent research by the Bank of England suggests [distortion in the markets] reflects a rise in the markets’ credit concerns.

"This appears to sit comfortably with the recent write-downs by some banks and the ratings downgrades of some bond insurers, or 'monolines'. But it is also possible banks just want to hold more cash while the economic outlook is so uncertain.

"Either way, it might not be long before central banks respond….We wouldn’t be surprised to see the Bank soon re-widen the range of securities deemed acceptable and announce another round of three month money auctions.

"After all, such moves helped to narrow interbank spreads earlier this year."

However, money auctions from the Bank of England are only expected to have a short-term effect, so Capital Economics predicts further interest rate cuts from the monetary policy committee (MPC).

"Even if the Bank does step up its attempts to bring interbank rates back down, the MPC may still have to cut interest rates further than otherwise in order to support activity.

"While inflation concerns will prevent the committee from reducing rates aggressively in the near-term, we continue to think they will eventually fall all the way to around four per cent – somewhat lower than the markets currently expect."

So who controls interest rates and the rate you will pay when you remortgage?

The markets guided by the Bank of England, and perhaps the Bank of England guided by the markets. And at the end of the line your bank provides with the deal it thinks is competitive in the market – based on how much it pays to borrow and what its competitors are doing.

A briefing note from the Council of Mortgage Lenders this week sums it up: "The Bank base rate is just one of a range of factors that determine the cost of funds to lenders.

"It should not be assumed that a base rate reduction will automatically result in a cut in standard variable rates or discounted rates across the market: this is a commercial decision for individual lenders, and their responses are likely to vary."

The key is if you are trying to remortgage and think your rate is too high – look as far and wide as possible.