Gilt and interest rate futures plunged today as investors abandoned their bets on a rate cut this year, after hawkish comments by Mervyn King, the Governor of the Bank of England.

Mr King told a business audience late on Tuesday that policymakers were still worried about price pressures arising from high inflation expectations, firms’ pricing power and commodity prices.

He said that the economy would need to slow to keep inflation at its 2 per cent target.

Financial markets had already been scaling back expectations for a rate cut this year, but Mr King’s comments wiped out any prospect of a reduction from 5.75 per cent soon.

Mr King called for reforms, including new legislation, to help prevent any repeat of the Northern Rock debacle as he set out lessons from the affair and defended the Bank’s handling of the run on the Newcastle-based lender.

Mr King said that, as well as a more generous system to guarantee more of bank depositors’ funds, which the Treasury has said will be introduced, a new insolvency law for banks should be passed to give greater certainty to depositors that they will be protected.

He argued that the “single largest impediment” to dealing with Northern Rock has been the absence of a mechanism for the authorities to step in and ring-fence the money owed to retail deposit customers.

Such a system operated in the US, where regulators were obliged to step in early, in just this way, where a bank was in trouble, he noted.

“Legislation to create the powers to deal with a bank in this way seems to me the single most important necessary reform,” Mr King argued in a speech to business leaders in Belfast.

In addition, the Governor also called for banks’ liquidity, as well as the adequacy of the capital they held, to be made “central to their regulation”.

He emphasised, however, that regulation alone was not sufficient, and suggested that ensuring banks faced the right incentives to make sure they had access to liquid funds was one reason why bailing out lenders with lax standards was a bad idea.

Mr King added that the Bank of England also needed to identify a way of acting discreetly to prop up institutions in trouble without destabilising them further as the intervention became public.

“In an age of communication, where the news of a facility for Northern Rock was leaked even before it was officially announced, it may be difficult to adopt the quiet methods used by central banks in the past,” he said.

“We will, however, explore ways to restore the use of discretion in central bank operations.”

In an implicit criticism of the existing regime for preserving financial stability through a “tripartite” group of the Bank, the Treasury and the Financial Services Authority, Mr King conceded that the actions of the authorities over Northern Rock “seemed, at least initially, to fan the flames”.

But he defended the hardline stance he has taken during the worldwide credit squeeze of refusing to extend much greater amounts of central bank funding to the financial system without imposing a penalty interest rate.

Rejecting widespread attacks on his approach from City critics, Mr King insisted: “The role of the central bank is to ensure that the appropriate incentives are in place to discourage excessive risk-taking and the underpricing of risk and, in so doing, to avoid sowing the seeds of an even greater crisis in future. That we have done in each action we have taken.”

Reaction to Mr King's comments came as the Bank of England’s third offer of three-month money failed to attract any bids.

The liquidity injection was announced after the Northern Rock bank run.

The punitive interest rate of 6.75 per cent is likely to have deterred potential bidders.

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