UK interest rates rise to a 14-year high
UK interest rates rise to a 14-year high
The Monetary Policy Committee (MPC) voted by a majority of 7-2 to increase the Bank of England’s (BoE) main policy interest rate by 0.75% to 3%. This is the highest rate for 14 years, and the largest single meeting hike since 1989.
The BoE described the economic outlook as “challenging” as households and firms struggle with double digit inflation and a likely recession over the next couple of years.
Since the last MPC meeting in early August, the main change for the economic outlook has mostly been driven by fiscal policy. The previous Truss administration’s gamble of large unfunded fiscal stimulus was quickly undone with a series of policy U-turns, before the prime minister herself was ousted and replaced with the former chancellor Rishi Sunak.
However, some of the measures that were announced in the disastrous “mini-budget” survived, including the energy price guarantee (at least until April 2023) and the cut in national insurance contributions.
The fiscal support from these measures, while lowering inflation compared to the BoE’s last forecast in August, also support demand and reduce the extent of the recession forecast. Though not explicitly stated, the fiscal support meant that interest rates needed to rise by more than indicated back in August.
BoE governor Andrew Bailey stated in the press conference that the data on UK growth had been weaker than expected, though the labour market has been more robust. Although demand for labour is waning, conditions remain very tight, with the unemployment rate at its lowest level since 1974. This has mostly been driven by a rise in people exiting the workforce, for health reasons or otherwise. Indeed, recent labour market statistics show that there are more unfilled job vacancies in the UK than unemployed people actively seeing work, which is contributing to rising wage growth.
Commenting on the situation in the mortgage market, he explained that much of the rise in mortgage rates and the withdrawal of products was caused by rising interest rates in wholesale markets. This was in reaction to the political turbulence in Westminster. Bailey said that these rates were now coming back down, and so conditions in the mortgage market for fixed rates should improve. Of course, the BoE’s hike is raising the cost of borrowing for those on variable interest rates.
Inflation over the quarter has largely played out as the BoE expects. While energy and food inflation are anticipated to ease next year, the main concern remains domestically driven inflation, which is becoming more prominent.
Importantly, one of the key messages from the BoE update is that the peak in interest rates that was priced by financial markets (5.25% when the forecast was done, 4.75% today) is judged by the MPC to be too high. Such a peak would cause inflation to undershoot the 2% inflation target in later years. In an unusually direct message, Bailey stated that the Bank would not follow the market’s path, and so de-emphasised its updated forecast, which is conditioned on the market path.
The BoE also produced an alternative forecast where the Bank Rate is assumed to remain unchanged (3%). Without any change in the interest rates, inflation is forecast to return to target in early 2024. However, as Bailey explained, the risk to the inflation forecast in this scenario is highly skewed to the upside, and so the forecast should not be read to suggest interest rate hikes were done. In fact, Bailey suggested that further hikes were likely to be necessary in order to sustainably return inflation back to the BoE’s 2% target.
The dovish message from the BoE caused sterling to slide by 0.6% and 0.8% against the US dollar and euro respectively.
Looking ahead, we expect further rate rises in coming months, though the pace of hikes may ease from here. The Schroders forecast is for a peak of 4% in the Bank Rate, but the BoE may even undershoot this below-consensus estimate from us.
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