The Bank of England indicated yesterday that Britons should not expect further cuts in interest rates for at least two years. It warned that inflation would rise far above its previous forecasts and continue at levels well above the government’s target until earl 2010.

Bank governor, Mervyn King said the consequence of price increases would be “a squeeze on real take-home pay, which will slow consumer spending and output growth, perhaps sharply”.
He added that it was “quite possible we may get the odd quarter or two of negative growth”, but added that a recession was not the Bank’s central forecast.

Chancellor, Alistair darling said his unfunded £2.7bn tax cut would “support the economy when it needs to be supported”.

However, Mr King said the effects of the emergency budget would be “modest”.

The bank said inflation was likely to rise above 3 percent over the next few months and would remain more than one percent age point above its 2 percent target.

Every three months the independent bank will have to explain to the government how it will bring inflation back under control if it deviates by more than one percentage point from the target. Even though the UK economy will slow sharply, the banks inflation projections do not return to the 2 percent target until early 2010, which suggests they have no room for cuts until then.

The bank’s stance on monetary policy appears similar to that of the European Central bank.

Mr King contrasted his position with that of Ben Bernanke of the US Federal Reserve. “We did not fall prey to the sirens to cut interest rates further as some other central banks have done,’’ he said.

Over the past three days, the market has moved from expecting to cuts in UK rates to believing there will be none over the next year. Last night, prices in the overnight index swap market showed investors thought a UK rate rise was slightly more likely than a cut.

Mr King said the blame for higher inflation lay with surging energy and food prices, along with higher import prices. The bank also expects the price of gas and electricity to rise by a further 15 percent over the coming months.

Malcolm Barr of JPMorgan said: “The Monetary Policy Committee believes it has to tolerate a slowdown in growth which is sharp, takes the economy close to stagnation and continues well into 2009 if it is to control inflation risks.” Believing the message in the inflation report was clear.

As if to highlight the limited affect that interest rate reductions are having on the economy, today’s quarter point up in UK base rates by the Bank of England has hardly registered in the financial services sector. While it seems likely that more will follow, possibly in July and September, the difficult situation in the UK financial sector is far from over.

The rate announcement was followed by a wall of silence from the main lenders in the UK with many insisting that they would only pass on rate cuts “where possible”, and some actually reacting by putting up their mortgage rates (and taking away many of their reduced rate offers). The reason for the lack of action can be explained by what is happening with the LIBOR rate (the London Inter Bank Offer Rate) which is the rate at which financial institutions will lend and borrow money between each other. Normally the LIBOR rate is about 0.25% higher than the UK base rate, but at the moment it is about 0.75% higher (reflecting the increased risk and lack of capital), although it did reach a high of 1.15% greater than base rates back in September when the credit crunch really began to register.

In the press we will no doubt see claims that the banks are making extra margin while the rest of us struggle but the fact is that lending and borrowing is a risk related action, and the greater the risk of default, the higher the rate will be compared to the base rate. As we have covered on this blog on a number of occasions, the credit crunch is far from over and slowly but surely it will need to work its way through the system. The main turning point will come when the affects start to diminish and the position of both the UK economy and base rates are at that time, as well as the worldwide picture, will be vital. So what happens in the meantime?

The situation for at least the next 12 months looks very bleak, and while we will see speculation of further rate cuts and assistance from the authorities, as today has shown, the affect of base rates on this current situation is limited. More people will go bankrupt, more people will lose their homes and while there are savings that many of us can make in our daily lives, these may not be enough to save many from hardship.

More and more people are comparing the current situation to the depression of the early 1900s when economies around the world fell for a sustained period of time and people struggled under mountains of debt. Whether the world economy will actually fall into a depression is very unlikely but if we were to receive any more bad news, e.g. another large hike in the oil price, then there is the potential for things to get much worse before they get better.

We all need to tighten our belts and ride out this difficult situation until we start to see the light at the end of the tunnel, although it may be a case of easier said than done for many of us.

As we see yet another trimming of US interest rates many people are starting to ask whether this is the correct course of action to try and re-inflate the money markets around the world. While central banks around the world have either reduced rates, or are pondering imminent reductions, the credit crunch crisis is getting worse. In the UK we have seen the likes of Egg recall up to 160,000 of their credit cards to reduce the chances of default and we are seeing thousands of US citizens at serious risk of losing their homes. Is the interest rate option really the only one open?

The main benefit of falling interest rates is to reduce the cost of debt and try to bail out the business sector, which is after all the heart beat of any economy. Historically, interest rate changes take anything up to a year to have the desired effect but it is really the first stage in a long term recovery process. In the short term the more prominent affect of falling interest rates is usually an increase or stabilisation of the level of confidence in the economy. However, the credit crunch is something that very few people have experienced and is a real one-off situation. We have been through vaguely similar situations but on a much lighter scale, and ones which have been rectified with a few calming words from the worlds central banks and interest rate reductions.

In order for the world wide economy to pick up we need to see confidence returning to both the credit market and worldwide business arena. The stock markets around the world are crying out for good news but of late it has all been doom and gloom. Exactly when confidence in the worldwide economy will pick up is anyone’s guess, but while interest rates are part of the solution, the days of simply indicating a change in interest rate policy to “fix” the economy have gone.

Confidence is the name of the game and until we see signs that the worldwide economy has “bottomed out”, we may well be in for a whole lot more bad news before is gets better.

While news that UK base rates have been reduced by 0.25% has been greeted with relief in many areas of business, there are real fears that it is too little too late. In a week which saw the owners of the Egg credit card operation threaten to close down over 100,000 accounts, we are seeing yet further signs that the economy is set for a very tough 12 months to say the least. So what is actually happening?

The impact of the interest rate cut was reduced somewhat by the very fact that everyone in the financial markets knew that this was going to happen, on the back of recent US rate cuts. However, the concerns generated by the move by Egg have further highlighted the real problems underneath the surface, and the concerns that business growth will be severely dented in the short term by the economy and the lack of affordable finance. The Egg situation has been summarised as “house keeping”, but this is from a company who have been on of the leaders in the UK, a company who need to make the business pay and a company who appear to be genuinely concerned about the possible cases of default.

There will come a point whereby the continuous fall in interest rates will kick start the economy, although many believe that this is still some way off. What the markets really need at this moment in time is confidence in the British Government and the Bank of England. Many government figures are brushing off the Northern Rock situation as something unconnected, but the genuine lack of confidence in the skills of the government to handle this difficult financial situation is very much in the foreground.

Time will tell exactly how this current situation pans out, but the lack of confidence more than anything is causing as much trouble as “high” interest rates.

As we hear news that US interest rates have been slashed by three quarters of one percent there are high hopes that we may see similar action in the UK. However, will the Bank of England really see the need to take such action? Is the UK economy as bad as the US economy?

While there is no doubt that we will see further ongoing reductions in UK interest rates over the coming weeks and months, it seem very unlikely at this moment in time that we will see such a knee jerk reactions as that seen in the States. Let’s not forget that the credit crunch began in the US and it is the US housing market which is currently bearing the brunt, with record numbers of home owners on the verge of being evicted, personal debt at record levels and unemployment starting to move upwards.

Only this week we have seen massive billion dollar write-offs by some of America’s largest financial companies, many of whom where left with massive losses on bonds and other financial instruments when the sub-prime credit market collapsed. As yet we have not seen such large write-offs in the UK, but that does not mean that the UK financial sector has remained unscathed, more that loses (all be it smaller) have not yet been quantified.

So why is the UK economy potentially different to the US economy?

While there is, and always has been, a close correlation between the UK and US economies they are not currently at the same levels in the boom and bust cycles. Indeed the UK authorities have managed to reduce the often wild swings between the boom and bust cycles, where perhaps the US authorities have not been as successful. This has resulted in a stronger core UK economy although that said there will be a marked downturn in 2008, with many areas of business already seeing reduced demand.

The UK authorities need to strike a balance between pain for the economy and the consumer against a need to keep the rate of inflation under tight control. However, it looks as thought the government’s core target rate of around 2% will be breached within the next 12 months with the Bank of England suggesting that the rate could climb above 3% during this next phase of the economic cycle.

Either way the UK economy is in much better shape than its US counter-part where further over exuberance on behalf of the financial sector and the consumer has led us into the current situation. The UK consumer has long been a little more reserved that the US consumer, but there is still no doubt that 2008 will be a difficult period all round.

As we move towards a decline in worldwide business activity, a time when interest rates around the world will fall, many are starting to ask when they should consider re-financing their debts.  Is it time to do it now, or wait as long as possible?

While it may be tempting to take advantage of the recent reduction in interest rates in some areas of the world, those who can may well benefit from waiting a few months longer.  The UK for one is expected to see interest rates start to decline very soon, with recent indications by the Bank of England seemingly confirming this.  We are also in a situation where finance is still more expensive in real terms than it was 6 months ago, because there is less liquidity in markets, which has pushed money market lending rates higher.

If you are looking for a fixed rate refinancing of your debt, and you are able to hold on for a little longer without impacting upon your credit rating, it may well be beneficial to hold off any action for a little while.  We could see UK rates fall by more than one percentage point over the next 12 to 18 months, depending upon the performance f the economy.  Even this relatively small fall will offer many consumers, who have built up substantial debts, the chance to reduce their future debt repayments.

Each person’s situation will be different and there is no simple answer to the question, but it seems inevitable that the UK, US and other major countries around the world will be seeing lower interest rates in the not too distant future.

With all of the talk about credit crunches, a drying up of liquidity, the real question on the mind of the consumer is – When will markets return to normal? When will my credit card application be accepted? When will my mortgage go through?

The quick answer to that is, nobody really knows! While the initial credit concerns may be leaving the market, money is still tight with many companies retaining as much liquidity as possible just in case they need it themselves.  The Northern Rock debacle was a special situation, but it was brought on by the credit crunch and the reduction in the pool of money available.

Slowly but surely we are seeing more and more companies bring out depressing statements, financial companies are having to write down the value of some assets and shareholders are biting their finger nails awaiting the worst.  Markets are awash with stories that Northern Rock is effectively worthless and Barclays Bank are now in trouble, but it will all blow over in the end.

It could take up to another year for the full effects of the credit crunch to wash through the markets, and the attitude to risk will change for many.  The problem is that we have been here before, everything flying high, business booming and then the risks become greater as people look for a new approach a new angle – and then bang! One problem, such as the US sub-prime mortgage crisis, can make the whole market re-evaluate risk and pull in their horns, having a knock on effect to all areas of business.  Then slowly but surely confidence grows, and the whole process begins again – history is littered with them.

The credit crunch may be over, but the after effects are not and they will be with us for some time.

While there has been much talk in the press with regard to the future direction of UK interest rates, there does not seem to be an awful lot happening at the moment.  So will all of the doom and gloom surrounding the economy actually make a difference?

There is no doubt that over the next 12 months we will see a reduction in UK interest rates, but the speed of the fall and level at which they will bottom out is not yet clear – it will be dictated by what happens over the next few months.  So why are UK rates set to fall?

UK rates will fall due to a mixture of the slowing US economy, which will affect the overall world wide economy, the falling UK property market and the aftermath of the credit crunch.  With so much doom and gloom around many people are asking why rates have not yet begun to fall yet – and they are quite right to ask the question!

The reason why rates are yet to fall in the UK is because of the perceived threat from inflation and the risk which it still may hold in the short term.  A sharp reduction in UK rates could easily fuel the flames of inflation, with the oil price recently hitting an all time high – and oil a major influence on the costs associated with the calculation of inflation.

As soon as the possible threat of inflation reduces we should see the start of lower interest rates and with the economic news set to get worse in the short term, that moment should not be too far away. 

Despite the ongoing credit crunch, the fall in the housing market and the mounting debt crisis which many in the UK are now suffering, it seems that the Bank of England are not too keen to reduce interest rates.  Why?

The Bank of England have built their reputation on an independent cautious approach to financial management, often preferring to see problems play their way naturally through the system, rather than providing false support in the short term.  The Bank also have a duty to keep inflation under control, hence the reason why UK rates are at today’s level.

While there are many people who will disagree with the approach of the Bank, they continue to closely monitor the state of the UK financial market, and where needed they will act.  Many people forget that if the Bank were to rush in and reduce interest rates we may see the rebirth of inflation, and the untold problems which that can cause. 

The balancing act between managing the economy using the array of weapons to hand, and managing inflation, is often very difficult to bring together.  The Bank have shown in the past that they have the bottle and determination to “do the right thing” because if they were to pander to all of the various associations around the UK, can you imagine the confusing signals this would lead to?

Short term pain, long term gain – this very much sums up the approach of the Old Lady, and she has been around long enough to see it all!

While the clamour for a reduction in UK base rates has been growing over the last few days, it seems that the Bank of England are taking a firmer, longer term approach than their US and to a lesser extent European colleagues.  Despite massive pressure to reduce rates, they have held firm in the belief that a reduction now may be seen as fool hardy when the mist clears over the Northern Rock debacle.  So what are the prospects for the UK economy, and is a rate reduction inevitable?

At the moment the economic indicators are suggesting at best a softening of the UK economy, with spending under pressure and mixed signals from the housing market.  This all leads to the general opinion that the UK economy is slowing, a view which would seem sensible bearing in mind the recent credit crunch and the shock many consumers received  from the Northern Rock crisis.  But is a recession around the corner, or should a strengthening of the rate of inflation be our main worry?

Unless we see a drastic worsening of the credit crunch there seems little likelihood of the UK economy actually falling into a recession, although a slow down would seem a distinct possibility.  While the US and European banking authorities have signalled their intentions to reduce rates (with the US having already done so), many are seeing this as a panic reaction.  The Bank of England have always dealt with matters in a methodical fashion, and even in the worst days of the credit crunch there were no panic reactions. 

While some commend this type of strategy, there are many who are calling for the Bank to be more pro-active and reactionary - but this is the Bank of England we are talking about, a banking giant which has seen it all over the years.  The “Old Lady of Threadneedle Street” lives on……