Financial Market

The Federal reserve today cut interest rates by three quarters of a point to take interest rates to 3.5%, 90 minutes before US trading opened. The dramatic cut was drastic action taken by the FED in order to stop markets falling after Europe and Asia recorded record losses on Monday, when US markets were closed.

The cut failed to work however with US markets recording sharp falls when Wall Street opened for Tuesday trading. Throughout the course of Tuesday trading other markets had closed even further down on yesterday, indicating the US would too open down. The FTSE 100 briefly rallied upon news of the FEDs actions after falling 3% early on, only to fall back again later on.

The actions of the FED are a clear indication of its concern, and weren’t meant to meet until next week, making this cut something of a panic move.

The underlying factor is that the real economy has not changed much in the last week, and as such the FED would not have to act now to make a decision on interest rates. What has ushered this move is financial market developments that are threatening to impact the real economy.

In essence if financial markets panic about what is going on in the real economy it can affect the real economy, leading to a nightmare for economy policy makers, which is a feedback mechanism of the markets being spooked by the economy, feeding back into the economy, sending everything into a tail spin.

Therefore the rate cut by the FED is designed to prevent this tail spin, but at the same time destroys confidence.

For mechanical reasons rate cuts will make it easier to borrow money and buy shares, and therefore can be used to prop up stock markets, but when market is determined to fall it is difficult to stop it. This is a similar pattern to drastic rises what a quarter point rise tends not to have an effect on growth, another cut wont solve the current downturn, but this downward phase for many is seen as a correction of the upward phase seen over recent years.

It is hard to steer and control financial markets, and central banks will say it is there doctrine not to control stock markets but to stop the economy going into a spin and if that means further rate cuts then so be it.

The implications of the FEDs cut on the UK are expected to be minimal. The UK are based in sterling and the Bank of England shouldn’t feel any pressure by the Fed to cut UK interest rates accordingly. Central banks are however looking to perceive that they understand and are in control, which in turn does put some pressure on the Bank of England to act, making the expected cut next month even more of a certainty. A FED style out of hours meeting is unlikely though unless further chaos continues in the market.

In terms of the global volatility of markets witnessed over the past two days many do expect a bumpy year although not on the same levels, and as such many experts expect markets to settle down.

But it is important to understand that this market downturn is not like 9/11, this market downturn has an economic underpinning where world markets are trying to adapt their view of the American economy. World markets have been late in understanding the crisis facing the American economy and its decline over the past year. At the moment world markets are correcting itself in a sense, a process which can be messy. The Economy will settle down and markets will learn to live with where the economy will settle down, which in turn will bring an element of stability back.

Figures released toady by the Consumer Prices Index show UK inflation remained steady in December.

The Consumer Prices Index is the governments preferred measurement for UK inflation, and in December the figure held at 2.1% for the third consecutive month.

Putting the most pressure on UK inflation was the continuing high prices of food according to the Office for National Statistics.

While the rise in the cost of food was offset by falling electricity and gas bills in December (7% annual decline in - the steepest such fall since comparable records began in January 1997), preventing annual CPI inflation moving higher still, energy companies are starting to rise their prices once again.

The Retail Price Index inflation measurement, which includes mortgage interest payments, eased to 4% from 4.3% in November.

Although holding at 2.1% the UK inflation figure still holds above the Bank of England’s 2% target figure, which continues to highlight the dangers of rate cuts in order to boost economic growth.

The figures were released at the same time as additional figures which showed annual factory gate price inflation running at its highest rate for more than 16 years.

The MPC cut base rates from 5.75% to 5.5% on December 6, and economists are forecasting a further quarter-point reduction next month. This data will however provide the MPC with food for thought as it weighs worrying price pressures against the increasing danger of a sharp economic slowdown.

Upon news that the UK housing market will stagnate in the next twelve months and the prediction that house will not rise for the first time in ten years, it seems that the increasing pressure on first time buyers may be relieved, even if only temporarily.

In addition to this news Halifax last month released figures detailing falling house prices for the third consecutive month.

However first time buyers wont be as happy to know that house prices will fail to drop to the levels seen in the recession of the 1990’s due to ‘high employment levels and sound economic fundamentals’, and is widely predicted the volume of property transactions would carry the brunt of the slowdown, expected to fall by 15 percent.

Claims of a slowing economy were further backed up with a survey claiming high street sales are growing at their slowest rate for almost a year, and restaurants and pubs are suffering, as indebted consumers stop to think. As Britain now accounts for more than two-thirds of the EU’s entire credit card debt, spending trends are even more reliant on Bank of England changes.

In response to a slowing economy and subsequent cooling off in the housing market, the Bank of England recently cut interest rates to 5.5 percent.

With this cut in interest rates it seems consumers are more willing to spend in the high street, with this pattern trickling through to the housing sector in due course, reducing the expected impact on dropping buying levels.

But with this cut dubbed the first of a series of interest rate cuts a new threat emerges, and the battle for the monetary policy committee now is trading off the threat of inflation to the threat of a slowing economy.

It is true inflation is becoming an increased worry for many experts and with goods leaving factories reaching there highest prices in 16 years, last months output price annual inflation hit 4.5 percent, up from 3.8 percent in October.

A slowing economy eases inflation, and the five interest rate rises of 2007 were intended to curb it, but inflation is still up. In the event of more interest rate cuts we will only see a boost to consumer spending to sustain a slowing economy temporarily, resulting in even greater pressures on inflation.