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Interest rates cut to boost economies

By: BILL BLEVINS

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Bill Blevins is Managing Director of Blevins Franks. He has specialised in expatriate investment and tax planning for over 35 years. He has written books and gives lectures on this subject in Southern Europe and the UK.

THE BANK of England (BoE) has cut interest rates for a second time in three months to 5.25 per cent in a bid to stave off a slowing economy.

The previous rate cut was in December when it dropped from 5.75 per cent to 5.5 per cent. Prior to that the interest rate had climbed steadily from 4.5 per cent in August 2005 to 5.75 per cent in July 2007, where it remained until the quarter-point cut in December.

The BoE cited a deteriorating global growth outlook, disruption of global financial markets and lending restrictions as reasons for the cut. Inflation remained a major concern.

In a statement, the BoE reported that credit conditions for households and businesses are tightening and consumer spending growth appears to have eased.

“Although the substantial fall in the Sterling exchange rate is likely to promote re-balancing of total demand, output growth has moderated to around its historical average rate and business surveys suggest that further slowing is in prospect. These developments pose downside risks to the outlook for inflation.”

In January, UK inflation hit 2.2 per cent, up from 2.1 per cent in December.

It is the highest rate since June 2007 and over the two per cent target.

Higher energy and food prices were the main causes and it is these two forces which are expected to raise inflation further in the coming months, possibly quite sharply.

Added to that, the weak pound will boost import costs.

The Bank commented: “The Committee needs to balance the risk that a sharp slowing in activity pulls inflation below the target in the medium term against the risk that elevated inflation expectations keep inflation above target.”

Higher food and fuel bills are hitting people’s pockets. Gas and electricity prices have risen by about 15 per cent and manufacturers increased their prices at the fastest rate in 16 years in December.

There is worry that inflationary pressures will push the inflation rate to three per cent when the Bank’s governor will have to write a letter of explanation to the Chancellor of the Exchequer.

The reduction in the interest rate was widely expected following the effects of the global economic crisis.

The Bank’s governor, Mervyn King, had indicated a fortnight earlier that a fall was likely because high borrowing costs were restricting consumer spending.

The Bank has had a tough decision in weighing a weakening economy against inflation restraint.

Economists forecast that the interest rate would drop further but slowly to 4.5 per cent or four per cent by the end of the year or the middle of 2009.

The lower interest rate should be good news for the depressed housing market and for borrowers who should see their mortgage repayments go down.

Following the BoE’s interest rate announcement, some leading mortgage providers announced they would be cutting their mortgage rates by a quarter-point although there are reports that at least 10 mortgage lenders have not passed on the earlier interest rate cut and so their mortgage margins remain more generous and their rates inflated.

Eurozone hold

The European Central Bank (ECB) kept its interest rate on hold at four per cent in February in a continuing effort to hold back rampant inflation which hit a 14 year high of 3.2 per cent in January.

The Bank’s target for inflation is “below but close” to two per cent.

The interest rate has been at four per cent since last June when the ECB did not make a cut to counterbalance fallout from the credit crunch.

However, ECB president Jean-Claude Trichet has not ruled out cuts for the future.

He said that “uncertainty about the prospects for economic growth is unusually high and the risks surrounding the outlook for economic activity lie on the downside”.

He added that strong upward pressure on inflation in the short-term stemmed mainly from commodity prices, in particular oil and food, in recent months.

Analysts feel that the ECB’s recent concern about economic outlook has paved the way for an interest rate cut possibly in April.

US rates

The US has slashed interest rates drastically to halt a threatening recession.

In an emergency move on January 22, the Federal Bank announced a 0.75 per cent cut from 4.25 per cent to 3.5 per cent.

Then, at its schedule rate meeting on January 31, it axed the rate by a further 0.5 per cent to three per cent, its lowest level since 2005.

It has been described as the most aggressive set of reductions since the 1980s.

The US’s economy grew at a minimal rate of 0.6 per cent in the last quarter of 2007 compared with the previous quarter of over four per cent.

Growth in the US economy in 2007 at 2.2 per cent was the weakest since 2002 when it grew at 1.6 per cent following the dotcom crash and 9/11 terrorist attacks.

The Federal Bank feared that the “downside risks” to the economy warranted the dramatic cuts and would bolster the global financial markets and in turn loosen the tightening of credit available to businesses and householders.

The drastic rate cuts were also intended to reverse the US housing market slump.

The Federal Open Market Committee that sets the US interest rate stated that it would “continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks”.

Analysts seized on the term “timely manner” viewing it as an indication that the Federal Bank would shave the rate further in the near future, although the next cut is not expected to be as ruthless as those in January.