Managing The UK Rate Economy

While the financial market in the UK is amongst the most developed of any country in the world, there are still only a handful of factors which can really impact upon UK rates of interest, UK rates of return and UK base rates. However, this small band of factors can often have a massive influence over the direction of the economy , stock market and returns available in the UK.

Money Markets
As we have seen over the last few months, in the aftermath of the US sub-prime market fallout, the world wide money markets can have a massive impact upon the cost of borrowing for both private individuals and businesses. As the sub-prime situation in the US continued to deteriorate we saw the start of what has become a long and prolonged credit crunch. But what is actually happening?

As the debt crisis in the US worsened we saw many companies pulling in their liquidity (i.e. “free money”) which they would normally have made available to the world wide money markets – the markets which allow companies to borrow money overnight, short term, medium term and longer term at a cost. As debt instruments which had been created using an array of debt exposure began to unravel (with many ending up virtually worthless) we saw the asset base of many companies shrink substantially. A trickle of reduced liquidity soon turned into a flood and before long we saw borrowing rates rise sharply due to a lack of “liquidity” in the markets – i.e. fewer people willing to lend money, which meant more risk to those staying in the market. This increased risk led to the need for a greater return to offset the added risk, hence the sharp rise in borrowing costs. How does this affect the economy?

The expansion, and often day to day running of many businesses, is highly dependant on the cost of financing such actions. As finance costs began to rise many companies were forced to cut back on their investment programs and look to make savings elsewhere – with job cuts the only option for many. As each cost saving exercise was announced, each redundancy meant less money for the UK retail sector which is now leading to a slow down in the UK economy. Indeed UK money market borrowing rates are still higher than UK bases rates (which are governed by the Bank of England) leading to central banks around the world looking to inject liquidity into the markets to bring money market rates more into line. This situation cannot go on forever and many central banks have taken the decision to let the market suffer some pain from “the over exuberances” of the past, in the hope that it will teach them a lesson to be more careful – whether this message hits home remains to be seen.

Inflation Rate
Inflation is a very difficult beast to control and very often just at that moment when you think it is under control it can roar back into life. Inflation is effectively the ongoing change in the price of an item, although the UK rate of inflation is calculated using the price of a “basket” of goods which reflect everyday life, including a TV, Car, Petrol, etc, etc. Even though many people will have you believe that any inflation is bad for the economy, this is not correct, and there needs to be a balance between the rate of inflation and the amount of income each adult person in the UK receives.

To give an example, if the general rate of inflation was 5% per annum, you would expect your cost of living to rise by 5%, but if your income only rose by lets say 2% then your cost of living has increased by a net 3% over and above the rise in your income. In other words you would not be able to live the lifestyle you had been living and there would be a need to cut your expenditure. A cut in expenditure by everyone in the UK (no matter how small) would filter through to the economy at some stage and we would see a reduction in retail sales. As retail sales become more competitive many retailers would be forced to lower their prices to attract the shrinking pool of money at the consumer’s disposal.

This reduction in prices would reduce both corporate income and profitability and eventually lead to more cost cuts – i.e. job losses, which would then lead to weaker consumer spending, and around we go again. This downwards pressure can often be difficult to turn around and does cause tensions between the government and the public sector, with the government looking to reign in short term spending by reducing wage rises, which would in turn bring down the general rate of inflation (i.e. the cost of the basket of goods used to measure inflation).

In summary borrowing rates and the rate of inflation have a major impact upon the economy of any country in the world. A lacklustre economy can wreck the mortgage loans market, kill the opportunity to refinance second mortgages and eliminate any chances for those looking to refinancing with poor credit ratings. It takes careful managing of the economy by the respective governments to ensure both over exuberance and high inflation periods are short lived and the economy returns to a long term steady growth pattern – easier said than done! www.ukrate.com