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Thursday, 8 February, 2001, 12:05 GMT
Q&A: What interest rate cut means

The Bank of England's Monetary Policy committee has decided to cut interest rates. Dharshini David, BBC economics reporter, examines why the decision was taken and what effect it will have.

How does the Bank of England set interest rates?

The cost of borrowing is set by the Bank's Monetary Policy Committee. Its remit is to ensure inflation, excluding interest rates, is as close as possible to 2.5%.

The nine-strong panel meet for two days once a month. At the end of the meeting, the committee decides the level of interest rates by majority vote, and the announcement is made at noon.

The Governor of the Bank, Sir Edward George has the casting vote if there is no majority.

Why did the MPC decide to cut interest rates?

The fall in the cost of borrowing had been widely expected. At the MPC's meeting last month, the panel only decided to leave rates unchanged by the narrowest of margins.

Since then, fears have grown that the US economy could be on the brink of recession, and interest rates have come down on the other side of the Atlantic.

While pundits say that the UK is well placed to weather the storm and avoid an outright slump, growth could still be hampered.

The latest figures, which showed UK growth already easing at the end of last year, may have tipped the balance in favour of lower rates.

Cutting the cost of borrowing should stimulate confidence and domestic demand in the UK, helping to offset the impact of a US slowdown.

Moreover, with inflation having remained below the target for nearly two years, the Bank of England has room to cut interest rates, without worrying that the cost of living is about to soar.

What do lower interest rates mean for households?

In general, an interest rate cut makes it cheaper to borrow money - such as mortgages - but also reduces the income savers receive.

The interest rate the Bank of England sets is the one it uses when dealing with money markets.

It is up to individual commercial banks whether or not it passes on any changes to its borrowers and savers.

For borrowers, it is not always the case that changes in the base rates means a change in variable mortgage rate - especially when base rates are falling.

If variable mortgage rates do fall by 0.25%, however, this would save a homeowner with a 50,000 mortgage about 8 per month. On a 100,000 mortgage, the saving would be about 16 per month, according to the Halifax.

Equally, interest rates for savers may not necessarily fall. But where they do, it will mean an even smaller return for the millions of savers who already earn little on their funds by the standards of the last thirty years or so.

Does this mean further rate cuts ahead?

While most experts predict the cost of borrowing will come down again, Thursday's move may not be the start of a rate-cutting spree.

The domestic economy is in very good health. Consumer spending is robust, while the housing market is buoyant.

While a large tax give-away seems unlikely in the March Budget, consumers may still end up with more cash in their pockets.

And with many workers receiving new pay awards over the spring - and in some cases, bonuses - households seem set to be better off.

Against this background, the MPC may not want to cut rates too far or too fast - or else risk the economy overheating.

Most experts predict that interest rates will only fall to 5.5%, unless the US takes an unexpectedly sharp turn for the worse.

Indeed, some say that rates could be on their way up again by the end of the year.

How effective is the Bank of England in setting interest rates?

The MPC was set up almost four years ago in May 1997, and is accountable to Parliament. During the first couple of years of its existence, it gained a reputation for being proactive when changing rates.

If inflation moves more than 1% away from its 2.5% target, on either side, the Governor has to write an open letter to the Chancellor of the Exchequer.

During the MPC's lifetime, inflation has hit its target in only a few months. However, over this time, inflation has never ventured outside of its "acceptable" range of 1.5% to 3.5%.

Officials at the Bank of England themselves admit this has been partly down to luck. Most experts predict that inflation will remain close to the target this year.

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