Last week, in light of the rather turbulent economic conditions, the Bank of England decided to reduce interest rates by a whopping 1.5 percentage points – from 4.5% to 3%. I should point out just how unusual this is – for many many years now, base rates have only been changed around 0.25 percentage points at a time. (Maybe I should point out here that a percentage point is not the same as a percentage increase/reduction. If the 4.5% rate was reduced by 1.5%, then the new rate would be 4.4325%)

Unusual it may be, but unwarranted it is most certainly not. In fact, for many months now, I have been wondering why the Bank refused to make a bold rate cut of somewhere around 1 percentage point. The speed and severity that the credit crisis, rising costs and general economic slowdown have come into effect signalled to me that drastic measures needed to take place.

Still, better late than never. Inflationary pressures are almost a non-issue all of a sudden – with a dramatic fall in oil prices from over $100 to around $65 a barrel, amongst other things.

I mentioned before in ‘Calming the Crisis‘ how banks are unlikely to pass on rate cuts because of the desire to increase their profit margins when the going is tough. It is even more unlikely to happen if rate cuts are miniscule. At least now, there will be pressure on commercial banks to pass on rate cuts (to some degree) as inter-bank lending should become much cheaper.

On a side note, with this cut, it looks like the yield curve will invert. Yield curves show the yield (interest rate) on government bonds for bonds of different lengths to maturity (when the bond stops paying you interest and you get your money back). The interest rate on bonds reflects the Central Bank’s base rate.

A ‘regular’ yield curve is upward sloping. This indicates that inflation is expected in the future, and so interest rates are expected to rise at a steady rate. Therefore an inverted, downward-sloping yield curve indicates that inflation, and hence interest rates, are expected to fall in future. For the investor, this means that a short term investment looks more attractive than a long term one, and so saving overall is discouraged. This should stimulate consumption – one of the main aims of reducing interest rates.

It will be interesting to see how other major economies react to all this in the coming months. The present conditions may be unsatisfactory for many, but it does make for interesting analysis nonetheless.