After a sustained period of rising interest rates to try and squeeze consumer demand, it looks as though the US Federal Reserve are about to back track on their recent strategy and introduce an interest rate cut to try and stimulate the economy and reduce the effects of the ongoing credit crunch. It is a major shift in policy but one which has been forced on them in reality.  So what next?

If the latest rumours are correct this will be the first reduction in US interest rates for over 12 months, and should mark the top of the interest rate cycle.  While a reduction in interest rates will assist the economy, there are also fears that it would introduce “cheap money” and feed the inflation monster again.  The authorities are in a very difficult situation because if they keep rates high for too long, the economy may stall and fall into recession.  However, if they reduce rates then they may well avert an imminent economic correction, but they would just be storing up problems for the future with a probable boom and bust scenario.

To be fair, the Federal Reserve have been fairly successful with their recent interest rate strategy, and had it not been for low grade mortgage sales by some of the sub prime mortgage providers, the economy would have been slowing at the moment, rather than having the potential to grind to a shuddering halt.

Will events in the US effect the direction of UK interest rates? Yes, so it is probably a good idea to keep an eye on developments in the US market over the days, weeks and months ahead.

While there are very few areas of finance which will not be directly effected by the ongoing credit crunch, which originated in the US but has since spread to all of the major economies of the world.  The fact that the lack of liquidity is having an immediate impact upon the supply of credit, and may well see short term money market rates pushed higher, will have a major impact upon credit cards.  But why?

Credit cards themselves are the most basic of debt instrument, and for each customers debt there needs to be a funding arrangement in place to cover that liability, if the person were not able to play.  The fact that short term credit rates have increased in the money markets, will soon impact upon everyday life - unless the situation can resolved as soon as possible.

While the financial institutions will try to resist any major changes for as long as possible, they cannot carry this short term increase in cost forever. There are many optimists in the market who feel the effects will be short lived, but we have only just seen the start.  Those companies already effected deeply by the situation, such as the original sub-prime lenders, will be trying desperately to reorganise their finances.  Those that fail will soon make their bad news public, which will see a sharp drop in confidence in the sector, putting yet more pressure on other companies.

The news that China and other areas of the Far East have become embroiled in these complicated financial instruments does not bode well, with a number of prominent American institutions originally looking at Far Eastern finance to bail them out of their current predicament.  It may take some time to unravel, but slowly but surely we will soon see more bad news filtering through.

While the last couple of years have seen UK base rates gradually rise higher and higher, it seems that recent rises are beginning to bite, and while the worst may not yet be over, we seem to be approaching the top of the interest rate cycle.  Recent comments from the Bank of England have indicted that while inflation is not yet under the 2% limit at which the authorities feel comfortable, it appears that the rate of inflation is starting to drop with a fall from 3.1% to 2.4% between March and June 2007.

While there were some one-off reasons as to why the rate dropped from 3.1% to 2.4%, i.e. a reduction in wholesale gas and electricity prices, there is more behind the fall.  The fact that housing repossessions have increased, and more people are starting to feel the economic pinch suggests that recent base rate rises are hitting home.

However, the property market is still a major headache for the Bank of England with prices still relatively high and showing very few signs of falling too far back.  While there is no doubt that buying pressure has cooled of late, helped by the fact that some houses are going for in excess of 6 times the average annual income, there is still demand in the background.  The housing market is the last major market that the Bank of England need to “crack” before they can take total control of the economy again - but there is a risk of other areas of the economy suffering yet further as we wait for the housing boom to subside.

Many experts are forecasting a rise to 6% base rates between now and March 2008, something which should hopefully mark the end of the base rate up trend.  However, until the trend actually turns, a number of the UK population may suffer further financial hardship in the short to medium term.

It may not be something that we think about a lot but interest rates actually have a massive impact on all of our lives. Whether you live in a heavily mortgaged house, have a large amount of savings stashed away or find yourself somewhere between these two extremes - interest rates effect all of us. Recently, they just seem to keep rising and rising. On 7th July 2007 the Bank of England increased interest rates by 0.25% to their current level of 5.75%, the highest rate of interest for the past six and a half years.

If you have a mortgage of around ,000, which is about the average level for home owners in the UK, you will be left paying an additional two hundred pounds per year. As a proportion of your whole mortgage payment it may seem insignificant but it is actually a fairly large increase for mortgage payers to face, especially those that have opted to pay interest only. To make matters worse, this is just the latest in a long line of interest rate rises, which have seen the average monthly mortgage payment increase by around since last August.

On the flip side of the coin (no pun intended), the rise in interest rates is actually a good thing for savers. If their bank does decide to pass the increase on to their clients then they will see the interest that they collect from their savings each month, increase. As it is a percentage increase, the more you save, the more you will benefit from the latest interest rate rise.

People at the Bank of England seem to suggest that inflationary pressures remain high. However, most analysts believe the Bank should wait for the latest increase to take effect, before deciding to elevate interest rates even further. They warn that any further rise in interest rates could leave borrowers unable to make their payments, resulting in them losing their homes. This could be just as bad for the British economy.

The Bank of England, occasionally referred to as ‘The Old Lady of Threadneedle Street’ or even just ‘The Old Lady’,  is the central bank of the United Kingdom. One of its many functions is to be the banker and debt manager of the British government and it was founded for this purpose in 1694 by Scotsman William Paterson.

It started with just seventeen clerks and two gatekeepers. However, since then the Bank has progressed and its roles are now many and varied. The Bank of England has had an interesting history, moving to Threadneedle Street in 1734, leaving the gold standard in 1931, being nationalised in 1946 and gaining independence in 1997. Mervyn King is the current governor of the Bank of England, he succeeded Sir Edward George in June 2003. Andrew Bailey is the current chief cashier, Merlyn Lowther was chief cashier before Bailey, and was the first woman to hold this position in the whole of the Bank’s history.

The role of the Bank of England is to decide the monetary policy of the United Kingdom through the Monetary Policy Committee. The most famous role of the Bank of England is to set interest rates. This effects the gains of saving and the costs of borrowing. Setting interest rates is a major tool used by the Bank to ensure rates of inflation do not rise out of control, which could lead to hyperinflation and the collapse of the British economy. It is worth noting that this is no small task, it was hyperinflation in the Weimar Republic of post-World War One, Germany that led to the global Great Depression of the 1930s.

As well as setting interest rates, the Bank of England is responsible for issuing notes. Up until 1855 each note had to be signed by a cashier. The bank notes must be extremely hard to reproduce to prevent forgeries from entering into the economy without anyone realising. In fact, during World War Two, the Germans had planned to drop £500,000 of counterfeit money into Britain to destabilise the economy. This serves to highlight the importance of the Bank’s role.

If you are looking at buying a home you want to get the best interest rate possible. In order to do this you need to know the current interest rates and where they are forecasted to be in the future. As of July the fixed rate mortgage interest rates have increased but only by approximately half a percent.

There are reasons behind this rise of interest rates. That’s because inflation is increasing. Consumers are confident in the economy and they are out buying clothing, electronics, and the like all the while groceries and the like are increasing in price. Since consumers are confident in the economy and prices are increasing thanks to bad weather, wars, ethanol production, and the like it is sure that the grocery stores will pass the buck to the consumers. So, expect to see prices going up all over the place because that’s what happens with inflation.

When the economy is unexpectedly stronger and inflation is higher then you can expect mortgage rates to increase as well. That’s what has been happening over the last few months and the reason behind the sudden rise in interest rates.

As interest rates increase the housing market will slow down a bit because mortgage companies begin to make it harder for individuals to get a home loan and harder to refinance existing loans. When interest rates are down it seems like anyone can get a home loan. It sounds kind of crazy but that’s just the way it goes. And who would expect for the mortgage sector to work in a logical manner anyway? Regardless of the interest rates on the rise homeowners aren’t too concerned, at least not yet anyway.

In fact, the majority of homeowners believe that if they wanted to sell their house they could do so at their asking price. In addition, the majority of homeowners plan on improving their home in some way over the next year as well. So, American homeowners are confident in the economy and are not concerned about inflation or increasing interest rates. Again, at least not at the moment. Then, with all this confidence in the economy why are so few people planning on buying homes in the next five year?

Approximately 25% of consumers plan on buying a home in the next five years. That’s not very many! So it appears the economy is functioning on consumes buying small things and not the big things like homes. This results in investors getting a little anxious. Things in the economy aren’t working out like one would anticipate so what happens?

Investors start getting worried. If the economy can’t be forecasted with forecasting software then investors start worrying over their investments. When investors worry interest rates go up. That ‘s just the way it is and that is exactly what is happening right now.

Mortgage rates are pretty much the same they were last year this time and they have been on the rise for two months now. So, where are interest rates going? Forecasters anticipate that interest rates will rise throughout the summer and then start going back down again. Of course, anything could happen but it’s not forecasted that interest rates will continue to rise much more than the next couple months before going back down again.

As the interest rate cycle continues to move still higher, we are regularly hit with the news that this is good for savers who are feeling the full benefit, but who really makes the money as interest rates rise?

You will not be surprised to see that the banking corporations can very often increase their profit margins in a rising interest rate market, and the chances are that you will not even notice it.  This is done using a very simple trick - increase borrowing costs by more than savings rates, thereby increasing your profit margins in an instant - but does it really have a major impact?

Let us show you how the situation can work :-

Prior to the last interest rate rise, let us assume the following :-

Base Rates   5.50%

Consumer Saving Rates   5.25%

Consumer Borrowing Rates 6.50%

In this situation a bank would make 0.25% on each pound of savings, if they were to put that straight back on deposit, however if they were to lend that to a customer  they would make 1.25%.  The profit margin for each situation would be :-

Placing consumer savings on deposit :-

100 * (0.25/5.25) = 4.76% profit margin

Lending consumer savings to borrowers :-

100 * (1.25/5.25) = 23.8% profit margin

However, let us assume that interest rates rise to 5.75% (as they have), and consider the following changes :-

Base Rates   5.75%

Consumer Saving Rates   5.40%

Consumer Borrowing Rates 6.80%

As you will see, in this situation savings rates have increased by less than the rise in base rates, while borrowing rates have been increased by slightly more.

The calculations are now :-

Placing consumer savings on deposit :-

100 * (0.35/5.40) = 6.48% profit margin

Lending consumer savings to borrowers :-

100 * (1.40/5.40) = 25.92% profit margin

While these increases in the profit margin of the banks may not sound much on the face of it, when you consider that the industry deals in billions of pounds each year, even a small increase in profit margins can have a massive impact upon the profitability of a company. 

This is just one of the ways that the banks use interest rate rises to increase their profitability, a technique which very often goes unnoticed unless you actually sit down and work out the figures!

While many are still trying to work out how the recent interest rate rise will effect them, it seems that there may be more misery on the way fairly soon.  If analysts are correct, it appears that rates are set to rise yet again in the short term with a move to 6% (and beyond) expected very shortly.  But why are rates set to rise further?

We have a raft of economic indicators due out over the next seven days, with many expecting them to show :-

· little change in the ongoing demand for property - pushing prices still higher.

· strong consumer spending.

· a further increase in the rate of inflation.

These are all signs that the Bank of England had hoped would be diminishing after the recent round of interest rate rises, but it seems that the consumer has yet to react to the increased cost of borrowing.  This will dismay the Bank of England governors who had been encouraged by indications that spending was reducing a couple of months ago.  However, this proved to be a short term dip, and we are back on the road of strong consumer spending, with many predicting a sharper shock for the consumer, the higher interest rates rise.

Why is the consumer so intent on a spend, spend attitude?

It is difficult to see why the consumer has not yet appreciated the higher cost of borrowing, although this may be down to the fact that many home owners had been on cheap rate introductory mortgage offers, the vast majority of which will be coming to an end over the next 12 months.  With interest rates having doubled since many signed up, they are about to see a massive increase in their mortgage payments.

Over the last few months we have seen a slight increase in the bad debt provisions of the main banking groups in the UK, a sure sign that they expect an uncomfortable ride over the short to medium term - although not half as uncomfortable as many home owners with large mortgages!

While the housing market continues to bound along, taking only short breathers before pushing on further, the Bank of England are getting more and more concerned about the state of the UK economy.  Base rates have already been increased to 5.50% in what has been a sustained campaign for the last year, but the consumer does not seem to be taking much notice.

The Bank of England committee will be announcing their decision at 12 o’clock today, although many are already resigned to another increase in rates.  While there had been slim hopes that the property market may have topped last month, recent figures show the sector is still in a very firm upward trend.  Recent news regarding the rate of inflation has also been a little worrying, and these two factors are the main reasons why rates are most likely to rise.

The knock on effect to the already stretched consumer will be a rise in loan rates, credit card rates, etc although there will be some rest bite for those with savings who should see an increase in savings rates.  While it may not yet be raining for many of the UK population, there is no doubt that the storm clouds are gathering over the UK economy. 

The Bank of England have a very tricky situation which they have handled with care so far, but they now seem set to raise the stakes a little.  The committee are obviously keen to avoid any long running recession although it remains to be seen how the market will react to the expected news later today.