With the UK and European central banks announcing their decisions on interest rate changes at lunchtime today, the big question is, “Do we need lower rates now?”

“Durr! We always need lower interest rates so we can spend more, which is good for the economy. The stock market’s a mess and all those city types are calling for the Bank of England to pull its finger out”

Well, I’m not so sure, but before I get on my soapbox let’s keep it simple and start with the official interest rate and how it affects you and me. Then I’ll tell you why I don’t think it’s the most important interest rate at the moment.

The official interest rate is determined by the Bank of England’s Monetary Policy Committee (MPC) on the first Thursday of the month. The European Central Bank (ECB) sets the equivalent rate across the Euro-zone on the same day while the Federal Reserve’s Monetary Operations Policy Committee (now there’s a mouthful) meets eight times a year to set the ‘Fed funds rate’ in the US.
For a quick re-cap on what the MPC is and does read MCP, PC or MCP, Inflation Explained.

These rates govern the level that banks can borrow overnight funds from the central banks. They are the rates that’re featured on the 6 o’clock news and the front page of The Sun when there’s a change. They’re also the benchmark for tracker mortgages and savings accounts.

“So, what does all this mean in the real world then mate?”

OK, even keeping it brief involves a few paragraphs so if all you do is pay your mortgage and put your spare cash in the bank here’s your summary then you can switch back to You Tube:

Interest rates go up, savers are happy bunnies but borrowers inherit a scowl like a Cherie Blair smile. Interest rates go down, the reverse happens.

If you want an understanding of how interest rates affect the economy and markets then pour yourself a coffee and read on….

1) Higher rates hurt all of us that need to borrow money, whether as a loan or a mortgage. Higher rates mean more is taken out of our monthly salary, just after the taxman and before the beer allowance.

2) This hits companies that rely on non-essential sales to consumers (OK, perhaps with the Rugby World Cup next week a 42” plasma screen is essential, but you get the idea); firms like DSG (Dixons), Next, Kingfisher, Home Retail would suffer. Companies like Tescos and Sainsburys don’t suffer as badly as we still need to eat, drink and … errr …use their toilet paper.. Infact asset managers often split the companies they invest in into ‘cyclical’ stocks that are heavily affected by changes in interest rates and the underlying state of the economy, and ‘non-cyclical’ stocks which are less heavily affected.

3) Higher rates, or the expectation of high rates, generally leads to a higher currency; see Z’s explanation in FX And Interest Rates Or A Tuna Sandwich. A higher currency allows companies to import goods more cheaply (each £1 buys more foreign goods when the currency is higher). If imported goods get cheaper then home made goods have to fall in price to remain attractive to buyers. This, combined with the consumer’s reluctance to buy, leads to lower rates of inflation for some sectors and a squeeze on company profit margins.

4) Exporters suffer from the higher currency as it makes their goods more expensive to an overseas buyer (though, depending on the business, there might be some offsetting benefits if it buys the raw materials from abroad). If the goods are too expensive then the overseas buyer will look for cheaper alternatives.

5) If companies aren’t selling as much, or they’re not making enough money from what they do sell, or their borrowing costs are rising, they have to cut costs. And guess what it says on page one in the textbook How To Cut Costs In Business? Yep, get rid of some workers!

6) If you and I lose our jobs, or even if we are just worried that we might lose our jobs, we’re less likely to splash out on that romantic weekend away in France (even if the World Cup is only on every 4 years). In fact, we’re less likely to spend money on a lot of things that aren’t really necessary. So non-essential sales to consumers drops and hey ho, we are back to the beginning.

7) The other bit that should be included is that if people have less money they can’t keep paying more for a house so house prices fall, which is bad for builders like Persimmon and Taylor Wimpey. Now, I know this has happened a bit in Ireland, but it just hasn’t happened yet in the UK. OK, so the price of flats have fallen, and there could be a few houses in Sheffield and Tewksbury that won’t fetch too much, but so far interest rate rises have had little effect on dampening house prices.

8) For the effect of falling interest rates read the above and think the opposite - cheaper debt, lower savings, lower currency, higher imported inflation, more spending, more employment, Yep, OK you’re there.

“Still looks like a no-brainer to me. And like I said, all the smart boys are calling for a cut.”

Firstly, there are always groups with a vested interest in calling for lower rates. Funnily enough they’re usually representative bodies for retailers, business and anyone connected with making a mint out of the housing market. They don’t necessarily have a rounded view; lower rates mean they make more money-simple.

Secondly, inflation; too much to say, but for a brief re-cap read MCP, PC or MCP, Inflation Explained and scroll down to the second part of the article. But in summary, despite last month’s inflation falling below the target level set by the Government it’s far too early to say the battle is won. I would expect a rebound from last month’s figures and also the price of food isn’t getting cheaper. Even my missus has caught on that she needs more dough for a loaf of bread. If the MPC looks to be losing their battle with inflation then that will upset the bond markets and the cost of debt will rise. For an excellent explanation of bonds, yields and all that stuff see Z’s Bond Spaghetti parts I and II.

Thirdly, I don’t believe the main problem would be solved by a cut in the base rate. The big problem here in the UK is to do with the banks’ reluctance to lend to one another, in short because they no longer trust each other. They know that there are massive undisclosed losses from the recent sub-prime crisis, but they don’t know who, or how many of them, are hiding skeletons in their sub-prime cupboards. The Bank of England has offered to supply emergency funds at 6.75%, but only overnight.

The real problem has been in 3-month deposits, where banks lend and borrow funds for a fixed 3-month period at a fixed rate, usually a bit above base rate. This rate is called LIBOR (London Interbank Offer Rate), and will be the subject of a future article, but over the past month the 3-month LIBOR rate has gone from about 6% to 6.8%, more than 1% above base rates.

What the commercial banks are really fussing over isn’t a cut in base rates, but for the Bank of England to follow the example of other central banks and offer funds for a longer fixed period, preferably 3 months.

I’ll stake my lunchtime cheese on toast on there being no change in UK base rates at 12 o’clock, but I’ll be watching very carefully to see if there is an announcement of any changes to the funding arrangements.

The ECB follows with its interest rate announcement at 12.45pm. I don’t expect a change in rates there either, but cheese on toast is far too precious to risk on the actions of a group of European bankers. Monsieur Trichet’s press conference at 1.30 might be more revealing.