Meltdown 101: Why the world's interest rates vary

[November 07, 2008]  WASHINGTON (AP) -- European central banks cut their interest rates dramatically Thursday, but most of them are still higher than the Federal Reserve's 1 percent target rate. Which raises a question: If the financial meltdown is global in nature, why do interest rates vary so widely around the world?

The Bank of England, for example, announced a huge 1.5 percentage point cut Thursday, but its rate is still 3 percent. The European Central Bank is still at a 3.25 percent rate even after Thursday's half-point cut. Central banks in Switzerland and Denmark also cut rates -- though they too remain higher than the rate in the U.S.

While such differences may seem small, anyone with a mortgage knows the difference that even a tenth of a percentage point can make to the cost of a loan.

And, if you can believe it, Iceland's central bank has pegged its rate at 18 percent. Soon it will be cheaper for the whole country to simply use a credit card to borrow money.

Here are some questions and answers about the factors that affect interest rates around the world.

Q: What effect do central banks have on me?

A: The Federal Reserve is the U.S. central bank. When it cuts (or raises) its benchmark short-term interest rate, most major banks follow suit by cutting (or raising) the interest rate they charge on credit cards, home equity lines of credit and other consumer loans.

The Fed has cut rates twice this month, potentially helping U.S. borrowers. Unfortunately, today's steep cut by the Bank of England won't reduce your car payment or mortgage, unless you're reading this from England.

Q: Given our global economy, why are central banks' rates different?

A: Some central bankers are more concerned about inflation than others. Higher interest rates can curb inflation, while rates are generally cut when central banks want to spur faster economic growth -- though that carries the risk of increasing inflation.

Inflation jumped in Europe earlier this year, as it did in many other parts of the world, after the price of oil and many other commodities soared.

As the price of oil and farm goods such as corn and wheat declined this fall -- bringing inflation down with it -- the European Central Bank started to come under criticism for not cutting rates faster.

Simon Johnson, an economist at MIT's Sloan School of Management, said European officials "have been behind the curve in understanding the severity of the financial crisis and its impact on the broader economy."

Q: Would better coordination among central banks help counteract the economic slowdown?

A: Many economists think so. And central banks in the United States and Europe seemed to say as much Oct. 8, when six of them engaged in a coordinated rate cut.

The European banks are "recognizing the problem, but they're recognizing it late," Johnson said.

Q: Will the rate cuts help deal with the meltdown?

A: They are intended to help reverse the current economic slowdown, which is affecting Europe as well as the United States. The International Monetary Fund forecast Thursday that the 15 countries that use the euro will see their economies shrink by 0.5 percent next year, while the U.S. economy is projected to decline by 0.7 percent.

Q: So why is Iceland's rate at 18 percent?

A: Iceland's currency, the krona, plunged in value after three of its banks collapsed and were placed under government control in recent months. Increasing the rate can help attract capital, because those who lend the government money can expect a big rate of return on their investment. That translates into increased demand for Iceland's currency, which can prevent the exchange rate from worsening.

Another reason for the high interest rate: The country's central bank is forecasting 20 percent inflation next year, and it hopes to get that under control.

[Associated Press; By CHRISTOPHER S. RUGABER]

Copyright 2008 The Associated Press. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.