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US Federal Reserve Cuts Interest Rate

It is unlikely that the interest rate in the United States have ever been watched so closely the world over as it was on Tuesday 18 September.

The US Federal Reserve decided to cut interest rates for the first time in four years, taking them down to 4.75% in an attempt to prevent a recession. Pressure had been on the “Fed” to cut rates from their level of 5.25% to make it easier for Americans to repay debts after the housing market in the US slowed down so much that a full-blown recession became a real possibility. The cut was needed to help underpin consumer spending.

Most watchers though that a 0.25% cut was likely, but the Fed decided unanimously that 0.5% was required to give a boost to the economy, which has been slowing down ominously.

In addition the Fed cut the discount rate, which is the rate banks use to borrow money. This came down from 5.75% to 5.25%.

The watching world took heart from the cut and stock markets jumped in response. In the US the Dow Jones industrial average shot up by more than 200 points soon after the announcement. The cut by the Fed was partly in response to the growing impact of credit problems around world markets on the wider economy. It said: “the tightening of credit conditions has the potential to intensify the housing (market) correction and to restrain economic growth more generally.”

The last few years in the US and in particular the last year in the UK have seen a trend of rising interest rates, but the Fed was forced to cut the rate to bolster the economy.

So, what will the Bank of England do next? With problems in the UK, such as those afflicting Northern Rock, affecting consumer confidence adversely, and with inflation now at 1.8%, below the government target of 2%, there are strong suggestions that the Bank should cut UK rates from the current level of 5.75%. Mortgage holders will keep an anxious eye on things, but there has been evidence of late that there is less of a link than ever before between the base rate and mortgage rates, which have gone up recently despite the base rate being stable for two months.

This is the first time that Federal Reserve Chairman Ben Bernanke has overseen a rate cut. Wall Street financiers wanted a cut to help the credit problems across the country and re-ignite confidence in global markets, but the Fed does not want to run the risk of inflaming inflation. Interest rates are used by central banks as a tool to control inflation, raising them when prices threaten to rise too quickly.

It would appear that the Fed considered the risk of recession to be greater than the threat of inflation, as they took a half-percent cut. Former Fed Chairman Alan Greenspan did suggest that the threat of recession had increased as a result of market turmoil and falling house prices in the US. Other indicators have been a drop in US employment in August, and crumbling retail sales.

The Fed has not cut interest rates since 2003, when they dipped as low as 1%. It was at such low levels that sub-prime borrowers were tempted to get into property … and we know where that has led.

Tom Smith
27th September 2007

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