Interest rate cuts

Today’s (6 November 2008) is the largest cut in interest rates since 1981.

Economy

The theory is that if you cut interest rates it makes saving less attractive and borrowing cheaper. So people will have more money available and will spend more, which will get the economy going.

Unfortunately, I think in the vast majority of cases, the impact in the immediate future will be minimal. 

People are already saving at historically low rates, and there is a lack of supply of mortgages and banks are looking to boost their profitability, so are unlikely to pass on the full cut in their Standard Variable Rates or in new mortgage deals. However, those on Base Rate trackers will benefit significantly.

As we are in a global economy and demand for goods is global, the UK is not alone in entering into recession, it will take global interest rate cuts to have a real impact. 

A greater impact is likely to come from other stimuli, such as expenditure on infrastructure projects here and aboard and tax cuts Obama may give to lower earners.

Inflation

In the longer-term inflation will stay high or keep rising, as demand for resources intensifies through increased global demand – especially from China and India.

Over the short-term, however, inflation will fall and is already doing so. The reasons for this are the falling oil and energy price and the knock effect this will have on food prices and household bills. The emerging recession reduces demand for goods and services and limits the price increases companies can impose, and also will curtail demand for pay rises as employees are grateful to be in work.

The impact of interest rate cuts, even if they do feed through to the real economy, is not immediate and inflation is a backward looking measure. As a result I believe that the Monetary Policy Committee should have reacted sooner to the slowing economy and cut interest rates whilst inflation was still rising to combat the situation we’re now in.

Investments

Share prices are likely to remain volatile for the next couple of days whilst the markets react to shock at the magnitude of the interest rate cuts. But if this, in conjunction with the other measures being undertaken, gives sufficient stimulus to the economy and starts the move into recovery, then share prices will recover strongly. Having said that, not all companies will survive the downturn, so invest wisely!

Gilt and Corporate Bonds (loans to our government and to companies) will rise in value to maintain a yield in line with interest rates. Usually an interest rate move is factored into the price; however, even the most optimistic of commentators, myself included, did not predict more than a 1% cut.