What are the consequences of the reduction in UK interest rates?

Yesterday’s momentous 1.5% reduction in UK base rates has certainly grabbed the headlines in the UK and around the world but what does this actually mean for the economy and is this the end of the credit crunch?

While there are many factors to consider a number of people may be surprised to learn that the sharp reduction in UK base rates may not have the short-term desired effects you would expect and the government is desperate for. The main impetus for the move was the ongoing collapse of the UK property market and the ever depressing news on the UK economy as a whole but there really is so much more to this situation than meets the eye.

Consumer confidence

This is one of the areas where the rate reduction will be felt most as there will be an immediate uplift in consumer confidence although how this actually transcribes towards increased economic activity and spending remains to be seen. Even though the UK consumer may feel happier in themselves this does not escape the fact that there is very little money around at the moment, employment prospects are bleak and the cost of living (although it looks as if it will fall slightly) is still a lot higher than it was just 12 months ago.

Property market

In truth, this is one of the main targets for the interest rate reduction as the government and the Bank of England both know that without an improvement in this market the economy is literally fighting a losing battle. The vast majority of property owner incomes are being spent on covering mortgages and the ever increasing cost of owning a home in the UK. Contrary to popular belief, while the interest reduction will be well received by the market, it will not yet on its own stimulate a substantial recovery as many people expect.

The Banks

The banks, the government and the UK consumer all know who is in control at the moment, the finance sector!

Despite a concerted campaign by the government and a number of high-profile business figures the banks are just not willing to pass on base rate reductions at this moment in time. The main reason for this is the fact that the LIBOR rate (the rate at which banks lend to each other) has not fallen anywhere near the same amount as UK base rates over the last few months. The Bank of England could reduce rates to 1% but less than banks feel confident lending to each other and ultimately businesses this will have no impact whatsoever.

Initially after the UK rescue package was announced there was a reduction in the LIBOR rate although it still has some way to go before returning to former levels. This more than any other element of the UK economy holds the key to the recovery in the UK and it should be monitored by all involved in the financial markets and investment community.

The government

How ironic that the Bank of England base rate reduction came on the day of the Glenrothes by-election in Scotland, a seat which the Labour party took by the narrowest of margins. Even though the government acknowledge that base rates are not the key to a revival of the UK economy it is a subject which does grab the headlines and could in some circumstances give a boost to consumer confidence, although whether now is the time remains to be seen

Like so many in the UK, the government has an ulterior motive in ensuring a controlled pickup in the UK economy ahead of a possible election next year or 2010. Whether the government is putting its own aspirations ahead of those of the UK is a debate which has been ongoing for some months now with this scorched earth policy of spend, spend, spend starting to seriously impact upon the strength of the UK as a whole.

Stock markets

The cut in base rates has had a two toned effect on the UK stock market with some investors happy to see movement at last and looking to the future, while some are sceptical as to the reasons for the sharp reduction and the probability that the Bank of England is currently in receipt of information which suggests the UK economy is in more trouble than many realised. The stock market also plays a very important role in an eventual economic upturn as the ability to raise funds for future expansion or the repair of balance sheets should not be underestimated.

Property investors

While the vast majority of property investors in the UK have seen their financial stability shaken somewhat there are still many with liquid assets and liquid funds which they could use to acquire properties in the UK. However, many seem happy to wait on the sidelines until signs of a serious recovery and it is this band of investors who could light the spark of a possible recovery, or at least stability, in the UK property market. However as of yet there has been no indication of a sea change in opinion or more investment activity although some people do expect to see more signs of life in the short to medium term.

The future

While many areas of government, the investment community and the property market will be looking for a continued improvement in the prospects for the UK economy in the short to medium term the 1.5% reduction in UK base rates is unlikely to lead to this in itself. It will instil some extra confidence into the UK consumer market but with finance very thin on the ground to say the least many consumers have limited funds to spend even if they wanted to.

As has been mentioned on a number of occasions the banks, and more accurately the mortgage market, hold the key to the eventual recovery in the UK economy. Until they are willing to pass on the perceived benefits of interest-rate reductions such as those seen yesterday the prospects for the UK have not changed materially over the last 24 hours.

As and when the banks decide to loosen their purse strings remains to be seen but until we see increased liquidity in the money markets there is little chance of homeowners and the general consumer benefiting in any significant way from yesterday’s move.

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