PSigma has urged the Bank of England to cut interest rates to offset the deflationary domestic influences on the economy.

PSigma believes the Bank is dissociating the problems in the financial sector from the problems in the real economy. However, by not cutting interest rates aggressively enough, the asset management firm thinks they are allowing money markets to dictate interest rate policy and hence inter-bank rates remain too high.

Bill Mott, fund manager of PSigma’s income fund, said: “The sub-prime crisis has affected credit markets in general and created the potential for contamination into the general economy.

“It is now clear that banks are tightening the amount and terms of their lending, not only to households, but also to commercial and industrial borrowers. This leaves the Bank of England and other central banks with a dilemma – the need to provide the banking system with liquidity to avoid a debt crunch, but at the same time being wary of stimulating inflationary pressures when headline inflation is uncomfortably high due to higher oil, commodity and food prices.

PSigma says the outlook for world markets is totally dependent on the actions of central banks and whether they correctly judge the appropriate monetary response to the current situation.

Mott added: “It doesn’t matter whether UK interest rates are 5.75% or 3.75%, they will have no effect on the drivers of inflation. Indeed, it could be argued that higher prices from energy and food are more likely to affect wage demands if interest rates remain high and the man in the street has to suffer higher mortgage payments as well as higher energy and food bills.

“We believe that the current economic situation warrants significant interest rate cuts in the UK and elsewhere. Central banks will become increasingly aware of the necessity to cut interest rates in the next couple of months and they will move aggressively to do so. If they do not, then the outlook for markets will be bleak.”