The outlook for interest rates
In mid-September last year, when Bank Rate stood at 1.75%, I wrote here describing what I considered to be a reasonable outline for the path for interest rates in the UK. I suggested a target of 4.5%, perhaps reached by August 2023. I also admitted that I’d be slightly surprised if the Bank of England did get as far as that. In other words, I felt it wise to plan for 4.5% but my intuitions lay with a slightly lower terminal rate.
Last week, on 23 March, the Bank of England’s Monetary Policy Committee (MPC) voted to increase Bank Rate by 0.25%, taking it to 4.25%.
For my outline to prove oddly accurate, the Bank will need to hold rates steady in May and June, before hiking one last time in August. That’s not remotely implausible. Meanwhile, at a little under 4.5%, the current 4.25% rate is in line with my intuited target. Accordingly, I thought it useful to share an updated outlook. (Spoiler: I’d be a little less surprised if we make it to 4.5% now, but my sympathies still lie with a peak rate at the current level).
The most recent increase marks the eleventh consecutive hike in the British policy rate, tracking an increase from 0.1% in December 2021 to 4.25% in March 2023. That’s the fastest pace of increase we’ve seen for a generation, and it matches a similarly abrupt rise in inflation.
A day before the MPC was due to vote, the Office for National Statistics published its assessment for the year-on-year increase in the Consumer Price Index (CPI) for February. In the event, an accelerated rate – from 10.1% in January to 10.4% in February – stood in bold contrast to expectations at the Bank for something closer to 9.8%. The core rate of inflation (CPI less food, energy, alcohol and tobacco) increased too, from 5.8% to 6.2%.
In hindsight, the accelerated pace ought not to have been such a big surprise. The core rate in the eurozone, published a few days earlier, signaled a pick up from 5.3% to 5.6% and headline CPI inflation was higher on the month in Germany (9.2% to 9.3%), France (7.0% to 7.3%) and Ireland (7.5% to 8.1%), among others.
One of the underlying causes of the hurried pace is the same in the UK as it is in France and Germany, and will be immediately apparent to anybody that has tried to buy a lettuce, laitue, or kopfsalat of late. Compared with the same time last year, food prices are up 18.0% in Blighty, 14.8% in France, and 21.8% in Germany.
Besides food costs, the MPC noted ‘surprising strength’ in clothing and footwear bills before observing that those prices ‘tend to be volatile and could therefore prove less persistent’. Let’s hope that is the case. The MPC has a lot riding on decelerated inflation.
Indeed, the minutes from the March MPC meeting reveal a reinforced commitment in that direction. ‘Bank staff still expected CPI inflation to fall significantly in 2023 Q2…’ and ‘…to decline further beyond’. Their confidence is underpinned by ‘developments in administered energy prices’. Members discussed the recent decrease in the Dutch Title Transfer Facility (TTF) spot rate for example, which has seen wholesale prices for liquified natural gas fall from €58.3 per MWh at the time of the February meeting to €41.9 today. That’s relevant because the ‘gas’ sub-component in the CPI basket stands 129.4% higher than it was last year. There is a somewhat circuitous line of influence from prices in the Dutch TTF market to those you and I pay for gas, but assuming that TTF gas prices remain static until August, the year-on-year decrease in the TTF contract will amount to something like -79%. (I calculate the average price in August last year to be €201.0 with a peak as high as €303.6 on 26 August 2022). There is a similar, though less spectacular, pattern in oil prices too. The Brent Crude spot price stands at $74.6 today compared with $123.6 on 6 August 2022, marking a -40% fall.
But, while energy price declines will help to cool the hotter parts of the inflation basket, the MPC expects prices in the services sector of the economy to ‘remain broadly unchanged in the near term’. Unfortunately, services inflation is buoyed at 6.6%, significantly higher than the 2.0% inflation target. If we are to see CPI back to within the MPC’s comfort zone (1% to 3%), we will have to see services inflation come down too. (CPI has averaged 2.4% since the turn of the century, over which time services inflation has averaged 3.3% and goods inflation has averaged 1.5%).
So, while the MPC sees encouraging downward movements in energy prices (which in turn will have further less-direct downward effects on inflation in various goods), the same cannot yet be said of services inflation.
That is why seven of the nine-member MPC voted for the 0.25% increase established at the March meeting (the remaining two voted for rates to be held steady).
So where do we go from here? The answer is, of course, that I don’t know. I don’t know if inflation will sustain a decline toward the 2% target, or if it will get stuck somewhere above the 3% bound. And I don’t know if conditions in the British banking system will remain stable enough for rates to be sustained at or above the current level. The outlook is uncertain. All I can do is speculate…
And I am speculating in the direction of a pause at this moment in time. In fact, there are good reasons for the MPC to hold the main policy rate steady when next it meets in May.
First, is the deteriorating condition of the global banking system; in which British banks have an important role (HSBC, Barclays, and Standard Chartered are among those identified as ‘global systemically important banks’ for example). As it stands, the Bank of England’s Financial Policy Committee judges that the UK banking system maintains ‘robust capital and strong liquidity positions…’ sufficient to ‘…continue supporting the economy in a wide range of economic scenarios, including a period of higher interest rates’. And while I don’t doubt the resilience of British banks, I am a little concerned about the volatility that we are seeing in the market for G7 government bonds. Ideally, the central banks would foster a period of calm, and I think a pause would go some way to achieving that.
The second reason is that, although patchy, there are welcome signs that inflation is abating. In addition to the declines in energy prices, the growth in average weekly earnings has eased from 6.9% in March 2022 to 5.7% more recently. Market-implied rates of future inflation have also eased. I calculate the 5Y-5Y implied inflation rate to be 3.3% today, very close to the average over the last 23 years or so. The Bank of England/Ipsos Inflation Attitudes Survey also reveals expectations for calmer inflation in the next 12 months (3.9% compared with an average response of 3.1% over the 14 years of the survey’s life) and over the longer-term (3.0% compared with an average of 3.2%). If nothing else, the MPC will be gladdened to see that the current high rates of inflation are not becoming entrenched in the minds of consumers.
Finally, the first and second points combined present a case for a wait-and-see approach, at least in the short run. In the space of a little over 12 months, the Bank of England has raised rates from near zero to 4.25%. The full effect of those increases has not yet been felt across the economy – in central bank parlance interest rate movements have a ‘lagged and variable effect’. Take the example of those consumers with a 2-year or 5-year fixed-rate mortgage, a sizable proportion of which will remain unaffected by rate hikes thus far. The longer Bank Rate stays at the current level, the more effective it will be. A pause in the current hiking cycle would not represent a retreat in the fight against inflation.
What, then, is my updated outlook for interest rates, and how does that compare with prices in the market today?
Given the extraordinary level of uncertainty that is characteristic of the outlook, it feels a little unwise to stick with a 4.5% peak rate when the current rate is 4.25%. Accordingly, I’m going to nudge my terminal rate expectation toward 4.75% and target the August or September meetings to coincide with that peak.
Having said that, my intuition remains anchored around the current level. The Bank of England and the Federal Reserve have raised rates aggressively and the European Central Bank is following close behind. Right now, I’m seeing inverted yield curves in places I’ve never seen them before. That makes me feel uneasy.
Prices in the market are reflective of similar concerns. The most obvious manifestation of this is the yield on the 2-year gilt which has fallen precipitously, from 4.1% at the beginning of March to 3.2% a few days ago. (Gilts, treasuries, and bunds at the 2-year horizon are very sensitive to changes in expectations for policy interest rates). Beyond gilt yields, prices in the sterling swap market suggest to me that participants are positioning for Bank Rate to reach 4.5% ahead of August and to remain there until the close of the year. (There is, I think, a hint of a risk in prices that Bank Rate will peak at 4.75% in August). Further out, at the end of next year, Bank Rate is priced at 3.75% or thereabouts.
There is no meaningful difference between my expectations and market prices at this time. Accordingly, I’m not taking any large bets either way.