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Home » Finance Articles » Insurance Articles » Interest rate cut no cause for relief Articles

Interest rate cut no cause for relief

The UK's money markets are sounding alarm bells after the Bank of England confounded prior expectations by pushing through interest rate relief - even as oil continues to take a heavy toll on inflation.
 
A shift in priorities saw the Bank impose a 0.25 per cent cut to the base rate this week, primarily in response to warning flares from the Financial Services Authority (FSA) as well as a steady stream of reports about the faltering
property market. Before those reports, however, there were recurrent falls in the short sterling futures market - an indication that investors felt rates were unlikely to fall.
 
The market works by enabling investors to place bets on what level the base rate of interest will stand at in three month's time. Whenever experts believe it has overly-optimistic expectations of a rate cut, investors move in their droves to sell three-month sterling deposits, in turn driving down their value and realigning the market's rate prediction to a more appropriately-high level.
 
And with the Bank's latest inflation report raising doubts over the prospect of interest rate relief, that downward realignment of the market happened continuously in November - gradually lulling investors into a false of security
that the Bank's hawkish and unyielding stance would not waver to the threat posed by the credit crunch.
 
This prevailing belief - which dominated market activity for weeks - came in spite of the fact that analysts and experts from all corners of the economy have long been railing about the devastating impact of the crunch on the housing market and consumer spending - literally crying out for interest rate relief to offset any further dampening of growth.
 
In response to such concerns, the Monetary Policy Committee (MPC) had been distinctly muted, merely acknowledging that a cut was desirable and saying one could be in the in the offing in the longer-term. It acknowledged the toll that five rate hikes since last summer had taken on mortgage holders and borrowers,
but consistently cited concerns over inflation as a reason for keeping rates high.
 
November's Consumer Price Index (CPI) clocked up a higher-than-expected 2.1 per cent annual level of inflation - primarily due to the rising cost of crude oil.
Tightening of the oil market led to November crude prices hovering precariously close to the $100 (49) a barrel mark in the States, while on this side of the Atlantic petrol prices teetered close an equally significant psychological level
- 1 per litre. Higher oil prices mean higher inflation, and the Bank's ultimate remit is to keep inflation and not interest rates low.
 
The burden of rising oil prices filters down into almost all sectors of the economy by driving up transportation costs for the vast majority of manufacturers. With the Producer Price Index - more colloquially known as 'factory gate prices' - recording a 12-year-high level of inflation in October, a widely-predicted knock-on effect to the CPI materialised last month and this rise in the price of everyday consumer goods is ultimately what had stayed - and
investors thought would continue to stay - the MPC's increasingly jittery hand.
 
Their confidence was only emboldened by the fact that OPEC expressed little appetite for stepping-up oil extraction and the Treasury constantly scoffed at calls for lower fuel duty. And yet as early as mid-November the first inklings
of a shift in MPC policy had already begun to surface.
 
The Bank's latest Quarterly Inflation Report - the first since the credit crunch - predicted growth in the current financial climate would taper off to such a degree that the rate could safely fall to 5.3 per cent by the end of 2008. Much as the credit crunch caused the mortgage crisis, it was paradoxically being presented as its potential saviour - with the gradual easing of CPI pressure compounding a relatively-benign predicted average oil price of $74.43 (36) a barrel and, hypothetically at least, allowing the Bank to direct some relief towards the faltering housing market.
 
Next up was Nationwide's harrowing house price index, which recorded the biggest drop in property inflation for 12 years. Analysts slowly started fretting over the gravity of the situation and rumblings duly surfaced that the time might have come for a rate cut. In the immediate run-up to the decision, Paul Dales of Capital Economics said the call would be "one of the closest for some time," while Howard Archer of Global Insight said it "balanced on a knife edge".
 
The final straw, coming dramatically on the eve of the MPC's meeting, was a warning from the normally tight-lipped FSA that the credit crunch is set to worsen. With the authority predicting "significant consumer stress" to come -
not least of all for the 1.4 million homeowners whose short-term fixed-rate mortgages expire next year - the Bank was ultimately left with no choice but to heed their call and lower the rate to 5.5 per cent.
 
"The MPC has given an early Christmas present to homeowners and may have gone some way to pre-empting an economic slowdown in the months ahead," said Trevor Williams, chief economist for Lloyds TSB Corporate Markets.
 
His caveat: "Nevertheless, inflation remains the top priority for the MPC and further rate cuts will only happen if the economy continues to slow and inflationary pressure subsides." 



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