Until quite recently we believed the Bank of England (BoE) would refrain from further aggressive interest rate hikes in the UK.
However, as the facts have now changed, so has our view. Events of the past few weeks, incoming data, and a surprise 0.5 percentage point (pp) rise in the base rate, suggest that the BoE remains far from getting on top of inflation.
Consequently, we now anticipate interest rates to peak at 6.5% by the end of 2023, a full 1.5 pp higher than our previous forecast for a peak of 5.0% (see chart 1, below). This is one of the highest forecasts in the market and we anticipate rates at this level will drive the UK economy into a recession.
We forecast that the BoE will raise rates by 50 basis points (bps) in August and September, before slowing to 25 bps increments in November and December.
Unfortunately, the BoE is no longer able to wait and see how the interest rate rises so far will affect the economy.
We also cannot rule out that the path the bank seems now to find itself on, with the potential to disproportionately impact the housing market, will not result in financial stability issues.
What prioritising inflation over growth looks like
We know that interest rates work with long and variable lags, and it is not exactly clear yet what the effect of the 13 consecutive rate rises seen so far will be.
With its forecasting abilities under question, however, the BoE’s likely approach now comes with a risk of “policy error,” where it raises interest rates too high.
Perhaps more than any other developed economy central bank, the BoE is set on a course of prioritising inflation over growth. And it’s becoming increasingly clear that the trade-off for taming inflation will likely be a recession (see Regime shift: time to prioritise inflation over growth?).
The current level of UK GDP remains below where it was in September 2022, and so while the country has avoided a technical recession (two consecutive quarters of contraction), the environment is already fairly recessionary.
The increase in interest rates we now anticipate is likely to be felt by the end of 2023, and we forecast a recession to follow between Q4 2023 and Q2 2024, with a total fall in GDP of 0.6%.
With its forecasting abilities under intense scrutiny, last week’s 0.5 pp rate rise signified to us that the BoE has been shaken by these challenges, which have seen it agree to an external review of its forecasting processes.
We have consistently said that inflation would be higher than the BoE had been expecting. This is because the UK is suffering from a combination of European energy problems and US style tightness in its labour markets exacerbated by Brexit.
With regards to the latter, increased hurdles to hiring from overseas means companies are struggling to fill jobs with suitably skilled staff. This has left them fewer options to manage the longer-term trend of falling labour participation rates since the Covid-19 crisis.
Members of the Bank’s Monetary Policy Committee (MPC) rate setting body have recently said that they are abandoning their forecasts.
This development, combined with last week’s re-acceleration of hikes, now leads me to believe that the Bank will keep hiking until either inflation is close to being at target, or the market is no longer demanding rate rises.
Market has begun to consider rates peaking at 6.5%
The immediate market reaction following last week’s rate decision suggested a greater belief from investors that the BoE will do what is required to tame inflation.
The yields on longer dated gilts initially fell (prices rose) following the announcement, halting the sell-off seen in recent weeks. This sell-off has driven fixed-mortgage rates back to levels last seen during the “mini Budget” crisis of the autumn.
However, the argument is far from won. And we know this because in the past few days markets have begun to ascribe the probability, albeit a very low one (c.5% - see chart 2, above) of base interest rates now hitting 6.5% in 2023.
Should stronger-than-expected economic data keep on coming, this probability will build – and observing jobs market data, wage growth and core inflation I see no reason why it will not.
As little as a month ago we felt the BoE would use its forecasts of falling inflation to justify a pause in hikes by the autumn and then cuts in early 2024. But with its ability to make credible forecasts under question, the BoE now seems dependent on the incoming data to inform decisions.
Crucially, it appears that the Bank’s “reaction function” has changed.
Longer and more variable lags than the past?
Last week’s interest rate rise confirmed to us that the BoE lacks the credibility to adopt a wait and see approach as being taken by the US Federal Reserve, which paused rate hikes this month.
This suggests that the MPC will no longer target a level of rates, but instead focus on the rate of change in rates. It also suggests it will respond to data as it comes in, not too dissimilar to the approach of the European Central Bank.
Rising rates always affect the housing market with a lag, but this time around there are a number of reasons why the lags will be even longer and more variable than in the past.
Notably, UK households have taken advantage of very low interest rates and increased fixed-term mortgage products to reduce their near-term exposure. The share of households with a fixed-rate mortgage of two years or more has risen from 16% to 63% between 2012 and December 2022.
The BoE is under attack from those suggesting that interest rates should not be raised at all if they’ve not worked so far in lowering inflation.
However, the chancellor has publicly backed further hikes in recent days, while the prime minister said at the weekend that taming inflation through higher interest rates should be the key priority.
We agree, but unfortunately taming inflation is probably now going to involve inflicting more pain than it might otherwise have done.