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Last Updated: Thursday, 6 December 2007, 12:10 GMT
Q&A: Interest rate cut
Shoppers on the High Street
Shoppers are one of the biggest drivers of the UK's economic growth
The Bank of England has cut UK interest rates by a quarter of a percentage point to 5.5% from 5.75%.

But why is it cutting now; is the UK heading for a recession; and what effect will the rate cut have?

Why cut rates now?

The Bank of England is worried about the possibility of a sharp economic slowdown.

It believes that the effects of the credit crunch, which originated in the US mortgage market, are spreading to the UK.

That will make it more difficult for people to borrow money in order to spend, and consumer spending has driven Britain's recent strong economic growth.

At the same time, house prices are beginning to fall, making it harder for people to borrow money against the value of their property.

Remortgaging has also been another factor that has fuelled consumer spending.

Many experts, including the Organisation for Economic Cooperation Development and International Monetary Fund, expect the growth rate of the UK economy to slow from 3.1% this year to 2% next year.

Further rate cuts may be necessary next year, analysts say, and many are predicting interest rates may fall below 5%.

What about inflation?

The Bank of England does face a dilemma, because as well as the credit crunch, the world is facing higher commodity prices, especially for oil and fuel, which is boosting inflation.

The Bank hopes that the increase in the oil price will just have a one-off and limited impact, but any continued rise will boost inflation further.

And it is worried that people's expectations about inflation will also increase, so that they will no longer believe that the Bank's plan to keep inflation at 2% is credible.

However, the slowing economy should ease inflationary pressures; and the credit crunch has already, in effect, tightened monetary policy by making it more expensive and difficult for people to borrow money.

Is the UK facing a recession?

Most experts believe that the UK will escape a recession next year. A recession is defined as when an economy contracts and does not grow for at least six months.

They believe that some adjustment in the UK economy - with slower growth, especially in house prices, and less borrowing - is necessary to return to a more balanced environment.

This would lead to people saving more and spending less, returning borrowing to safer levels.

But there is a fear that people might over-react, especially if they see tight credit and falling house prices, and cut back their spending too sharply, leading to a downward spiral.

So far employment and earnings are still stable, although bonuses in the financial sector are likely to fall sharply.

And the hope is that exports will take up some of the slack from weaker domestic consumption.

What are the main risks?

No one is certain when the current turmoil in financial markets will end, and how seriously it will impact on consumer spending.

It is also not clear whether the housing market will merely slow, or actually show negative growth, next year.

And if there is a big recession in the US, then the UK, which relies heavily on the international economy, will be seriously affected.

Finally, government spending may have to be cut if the economic slowdown leads to weaker tax revenues and a bigger budget deficit.

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