World interest rates

What has happened?
The Federal Reserve, the world's most powerful bank, decided to reduce its key interest rate from 6% to 5.5% yesterday.

This doesn't sound like much of a change. Why does it matter?
Actually it is quite a big change. Interest rates rarely shift by a larger amount. And it is important for two reasons. Firstly, the cut comes on the back of a similar one earlier this month. This sends a clear signal around the globe that Alan Greenspan, head of the Federal Reserve and the most powerful financial chief in the world, believes interest rates should be lower. Secondly, this rapid rate cut increases the chance that the US economy will not fall into recession. That is good news for everyone, since the US economy is by far the largest in the world. When it falters, other economies, too, stop growing.

But why do interest rates affect the economy?
Because when interest rates are high, companies and people have to pay more to borrow money. As a result they are less likely to do so, and spend less, causing the economy to shrink. When interest rates are low, the reverse happens and economies begin to expand.

So why do interest rates ever rise?
To ensure that economies do not grow out of control. When this happens, inflation takes off - and that, too, causes economic problems.

Sounds like an exact science?
But really it is nothing of the sort. In recent years central governments and banks have begun to use interest rates as their chief tool for managing the economy. They raise and lower rates in the same way as a pilot uses flaps on an aeroplane. In both cases the aim is the same, to keep a level course. This doesn't always happen.

So will it work this time?
Probably. The US economy is showing signs of faltering, but it is a long way from a real recession. This recent rate cut may be enough to level things out. On top of that the European economy is still growing, as is Britain's.

What effect will the US rate cut have on Britain?
It makes it more likely that our interest rates will fall - already British rates have reached their likely high point. That means cheaper mortgages and ought to have the side benefit of causing the pound to drop in value against the euro, helping exporters. We'll know on February 8, when the Bank of England's monetary policy committee next meets.

Related article
US cuts rates to 5.5%

Useful links
Bank of England
European Central Bank
US Federal Reserve