UK interest rates: what next?
UK interest rates: what next?
28 September: Bank of England announces it will buy long-dated gilts
In response to the ongoing turbulence, the UK's central bank has moved to prop up the gilts market by announcing its intention to buy long-dated bonds.
In response, Azad Zangana, Senior European Economist and Strategist said:
"The Bank's decision to step in to stabilise the gilts markets with purchases makes sense in the short term, but this is ultimately a credibility issue with fiscal policy. This is the wrong time to be acting as lender of last resort, when it goes against the Bank's primary objective of fighting inflation. It seems that the BoE will fight the market instead of hike rates aggressively as the market is demanding, resulting in a worse outlook for sterling."
Azad also appeared on our Investor Download podcast to explain what's been going on and what might happen next. A recording and transcript of the podcast is available here.
26 September: How might the BoE react to market turbulence following the mini budget?
Following a dramatic fall in sterling and surging gilt yields, investors are asking if the Bank of England will need to step in and aggressively increase interest rates to help stabilise UK asset prices.
Azad Zangana, Senior European Economist and Strategist says: “If energy prices rise, it could create an uncapped liability for the government. This explains why gilt investors are so nervous right now. The government has never borrowed this much money when the Bank of England has not been conducting quantitative easing, which involves the Bank buying up large amounts of bonds itself.
“There is a concern the Bank won’t follow through and do what the market is telling it to do, which is to raise rates to 5.25% by the middle of next year and 5.5% the end of 2023 – international buyers of gilts are demanding higher rates to compensate them for what they now see as a greater risk of lending to the government.
“If it can, I suspect the Bank will avoid intervening with emergency rate rises given its past experiences of currency intervention such as Black Wednesday in 1992, when the UK was forced to withdraw from the European Exchange Rate Mechanism following a collapse in sterling. The Bank can, however, put out more hawkish statements between now and the next Monetary Policy Committee in November.”
Remi Olu-Pitan, Head of Multi-Asset Growth and Income Strategies says: “In multi-asset portfolios we are maintaining our cautious stance on UK assets despite the severe correction. The market is questioning the country’s fiscal credibility which is why we’re seeing such intense selling of gilts and sharp declines in sterling. We expect the Bank of England will need to step in to regain credibility by raising rates aggressively and signalling that it is willing to do “whatever it takes” to tackle inflation.”
Thursday 22 September – analysis following latest rate decision by BoE
The Bank of England (BoE) has raised its main policy interest rate, or the Bank Rate, by 0.5% to 2.25%. Azad Zangana, Senior European Economist and Strategist, gives his initial analysis following the news here: BoE disappoints investors as it lags other central banks
Scroll down for "Five key questions about interest rates answered"
WEDNESDAY 21 September – Bank of England to balance weaker growth, lower inflation against a “potentially big” fiscal stimulus.
At a ‘mini-Budget’ this Friday (23 September) the UK’s new chancellor Kwasi Kwarteng is expected to set out the government’s vision for the UK economy, alongside possible measures to further support it during the energy crisis.
The Bank of England’s (BoE) Monetary Policy Committee (MPC), meanwhile, convenes again tomorrow (22 September) to decide further changes in the country’s base interest rate.
We asked some of our experts what they are anticipating ahead of these two important events. They explain how they’re focussed on their possible impact on ‘core’ (as opposed to ‘headline’ tracked by the Consumer Prices Index, or CPI) inflation. By stripping out volatile items including oil and food, core inflation gives a clearer picture of underlying price trends.
Azad Zangana, Senior European Economist and Strategist, said: “The Bank of England is going to have to balance weaker growth and lower inflation against a potentially big fiscal stimulus which may raise core inflation down the road.
“We think the Bank will carry on hiking at a reasonably quick pace in the near term. It can afford to wait until the end of this year before deciding whether to pause or keep rising for a little bit longer.
“Rates, however, are currently expected to hit around 4.5%, so it may want to talk the market down from such a steep profile.” (see chart, below)
Ahead of Friday, the UK government has already capped household energy costs for the next two years and announced a six-month energy package to help get firms through the winter.
These are both examples of fiscal policy and, like monetary policy controlled by the BoE, are the means by which policymakers attempt to manage the economy, in these two instances from the immediate consequences of the energy crisis.
Such ‘fiscal stimulus’ could mean the recession which is now expected to sweep across many developed economies could be shallower in the UK than had been previously anticipated. However, the details of how this stimulus will be funded will be scrutinised.
Funding is expected to be by the issue of new government bonds, and international buyers of these bonds will be watching carefully – if they’re not convinced by the details, sterling could fall further.
Since the UK is heavily reliant on imports, a further fall in the value of sterling versus other major currencies could have further inflationary consequences.
Sue Noffke, Head of UK Equities, said: “Will the package of measures put a floor under sterling or will it lead to a further slide? That’s really important for inflation because we import so many goods.
“We can’t get away from the impact of weaker sterling on inflation. The chancellor will have to sell a vision of reform and attractive growth and the ability to repay any new debts.”
WEDNESDAY 7 September – experienced investors look through gloom as UK awaits response by new government to energy crisis
Rising inflation has been dubbed the “cost-of-living crisis”, driven largely by home energy bills. Rising interest rates intended to tame inflation are contributing to the income squeeze UK households now face on multiple fronts in the coming months.
Political uncertainty has added to the sense of fear around the outlook for the UK economy which is gripping some areas of the UK stock market and sterling. But as the country waits to hear the policies of new Prime Minster (PM) Liz Truss, experienced investors remain squarely focused on the long term.
Sue Noffke, Head of UK Equities, said: “Many investors are fearful of what lies ahead for UK equities given the many challenges the UK’s new PM faces. As long-term investors we are prepared to look through today’s gloom to identify the opportunities of the future, aware that history shows stock markets typically reach the bottom in advance of the worst news.”
The resignation of former premier Boris Johnson had put a block on further major policies being introduced until a new leader of the ruling Conservative Party was elected. Questions are now focused on how the new administration will support consumers and businesses amid the intensifying energy crisis.
Azad Zangana, Senior European Economist and Strategist, said: “Politicians are discovering that they are not immune from blame, as voters, who have become used to government help during difficult periods in recent years, expect governments to act with support once again.
“Measures to help with the cost-of-living crisis have so far totalled £37 billion (1.5% of GDP) and we will be keeping a very close eye on what additional packages may be unveiled by the new government.”
TUESDAY 9 August – oil majors: an investment bright spot amid high inflation, rising interest rates and slowing growth?
The UK oil sector increased dividends by 41% in the second quarter of 2022 compared to the second quarter of 2021 (see UK Dividend Monitor Q2 2022).
This arguably makes it an investment bright spot at a time when many countries, including the UK, are grappling with an inflation problem. Interest rates may need to rise significantly, possibly tipping economies into recession.
All the while, geopolitical uncertainties seem unlikely to abate soon (see What is the outlook for UK dividends in a less certain world?).
Sue Noffke, Head of UK Equities, said: “Many companies are now seeing inflation all the way through the supply chain from transport costs to materials prices, as well as higher wages, which they are struggling to pass on to their end customers, including under-pressure consumers.
“Investors in these businesses also have to consider the impact of taxes, including one-off levies, such as the 25% windfall tax on profits of oil companies operating in the UK and UK Continental Shelf, to apply until the end of 2025.
“We could see ‘stagflation’ when growth is low or slowing at the same time as inflation remaining high or rising. Major oil companies are highly cash generative businesses when oil prices are high and benefit from inflationary or stagflationary economic environments.
“The windfall tax reduces the attractiveness of investment in the UK at a crucial time for both energy security and funding energy transition. That said, as a proportion of their total size, the UK operations of the oil majors is small, and the impact on their share prices and values has been small too.”
THURSDAY 4 August – inflation unlikely to fall back as much as the BoE forecasting
The Bank of England (BoE) has raised its main policy interest rate, or the Bank Rate, from 1.25% to 1.75%. The Bank also published new economic forecasts. It expects consumer prices inflation (CPI) to rise to more than 13% in the fourth quarter of 2022 (more than when it last updated its forecasts in May) and eventually fall back after the UK enters a recession.
Azad Zangana, Senior European Economist and Strategist, said: “Looking ahead, the Bank is likely to keep raising interest rates even if it believes it has already done enough already. It may then be able to pause once inflation peaks, and the focus of the public turns towards the recessionary environment.
“Where we differ from the Bank in its assessment is that we do not believe that inflation will fall back by anywhere near as much as the BoE is forecasting. We see greater domestic inflationary pressures building, which will require even higher interest rates.
This is likely to stop the Bank cutting interest rates in 2023/24, as suggested by its forecast, but instead continue to maintain above neutral rates for longer, with the hope that inflation returns to target over a longer period of time.”
WEDNESDAY 13 July – UK's return to growth piles rate rise pressure on BoE
The Office for National Statistics confirmed today the UK economy enjoyed a strong month in May, growing by 0.5%, after shrinking 0.2% in April. This has potential implications for monetary policy.
The Bank of England (BoE) has to essentially “tighten” monetary policy, including raising interest rates, to restore balance between demand and supply of goods and services.
Schroders experts believe today’s news should further pressure the BoE to up the pace of interest rate rises.
Azad Zangana, Senior European Economist and Strategist, said: “This news should raise pressure on the BoE to raise interest rates faster to combat heightened inflation.
"The next BoE Monetary Policy Committee meeting on 4 August should deliver at least a 0.25% increase in interest rates.
“The argument for a larger rise, however, is strengthening.”
FRIDAY 1 July – rates for new mortgages rise 30% in six months
The “effective” interest rate – the actual interest rate paid – on newly drawn mortgages rose from 1.5% in November to 1.95% at the end of May, according to Bank of England data published today.
In December the Bank of England (BoE) became the first central bank of a G7 economy to raise interest rates since the pandemic. Mortgage costs, which are linked to Bank Rate, have risen as a result.
How significant is this to the UK housing market?
Azad Zangana, Senior European Economist and Strategist, said: “It is no surprise to see mortgage rates rise following the start of the rate hiking cycle by the Bank of England.
“Moreover, expectations of further rate rises are already feeding into the mortgage market.
“However, with the demographics of homeowners aging considerably over the past decade, the majority of households are mortgage free. In addition, most households have been able to take advantage of those low interest rates and had fixed their mortgages.
“This means that it will take longer for rising mortgage rates to have an impact on households and therefore house prices, though first time buyers are the first to feel the pain.”
WEDNESDAY 22 June
UK consumer inflation edged up to 9.1% in May, according to the Office for National Statistics. This is based on the annual change the Consumer Prices Index (CPI), as used to track the price changes facing end consumers of goods and services.
The Bank of England (BoE) raised the Bank Rate by 0.25% last week to 1.25%, but warned it may have to “act forcefully” to tame inflation. (see Bank of England fails to keep up with Fed and Bad news forces Fed to up its game)
Our economists here at Schroders currently see UK base rates peaking at 2.25% in the first quarter of 2023.
Interest rates, however, may rise more than they're anticipating in order to head off “second round” effects, they caution.
As the UK grapples with a national rail strike over pay and conditions, there is a risk the dispute may have wider implications for wages and inflation in other industries.
Our investment experts, however, remind us that not all companies are equally affected by inflationary pressures.
Those with “pricing power” may be better placed to recoup higher production costs by successfully raising prices for consumers.
How do second round inflation effects drive interest rates higher?
Azad Zangana, Senior European Economist and Strategist, said: “The risk is skewed towards even more rate rises, as signs of second round inflation pressures are becoming more evident, even if the BoE is not concerned by them yet.
“Second round pressures can occur as higher wages drive inflation higher still, at risk of round after round of wage and price rises, with expectations of inflation becoming a self-fulfilling prophesy.
“Because of the UK energy price cap we have not seen the full pass-through yet of energy price inflation. Most forecasters are looking for inflation to head to around 10% by the end of this year and stay quite elevated for most of next year as well.
“If you look at the consensus figures for next year, the UK is again forecast to be one of the highest in the developed world.
“The biggest area of risk with regards to worker disputes is going to be the public sector because a lot of the public sector pay settlements have been around 1-3%. And given where inflation is heading, that means very big pay cuts in real terms.
“On the private sector side the risks are less. Companies have been able to offer at least temporary bonuses to help with the cost of living, and we’ve seen a number of companies do that in recent weeks.
“That’s helpful since it reduces the pressure on the workforce in the near-term but at the same time doesn’t lock the companies into a permanent pay increase for following years. “
What are the implications of high inflation for investors?
Jean Roche, UK mid cap fund manager, said: “There are UK businesses with sufficient pricing power to withstand inflation raging at 9%.
“Despite the dire headlines we’ve seen companies in the retail, housebuilding and construction sectors report upbeat trading in recent months.
“There are plenty of specialist retailers catering to better-off households with cash to spend. Some of these companies with very niche products will be better able to pass on their own rising costs further supporting their earnings.
“Meanwhile, some areas which may appear discretionary are, to a degree, essential items, such as pet services, for instance.”
“Those companies with pricing power could come into their own as they’re better able to mitigate the impact of shortages and higher costs being experienced in many major economies at present.”
TUESDAY 7 June
Prime Minister Boris Johnson last night won a no-confidence vote, albeit by a smaller margin than expected (211 to 148 votes). The result is not anticipated to have immediate economic or market consequences.
However, at a time of high inflation and interest rate rises, investors are closely watching how political uncertainty might impact government spending plans.
Sue Noffke, head of UK equities, said: “The vote result is not a sea change as markets have already been pricing in political uncertainty. It wasn’t, however, the comfortable win he would have hoped for.
“We are asking ourselves if the government might bring forward spending plans to improve its popularity in the polls. The chancellor has scope to bring forward spending that he might have otherwise left until the autumn.
“If this were to happen, it might stoke inflation, which would make the Bank of England’s (BoE) job more difficult. Like most central banks around the world, the BoE is slightly behind the curve with raising interest rates.
“The Bank is assuming, however, that economic growth cools as inflation eats into real incomes and demand. Were the government to decide to accelerate its spending it may make it harder for the bank to control inflation.”
Azad Zangana, senior European economist and strategist, said: “Yesterday’s result was pretty poor, but it’s likely the prime minister will survive given he has a strong and loyal cabinet behind him.
“Also, we’re not expecting any change to the rules prohibiting another vote in the next 12 months.
“The government has lots of spending plans coming at a time when it’s under pressure due to high inflation and rates rising.”
“Longer term, however, we’ve not seen the tax cuts it will need to deliver to keep the party faithful onside. “
FRIDAY 27 May
As the Bank of England raises interest rates to cool inflationary pressures the UK government is simultaneously taking steps to alleviate the squeeze on the consumer.
On 26 May Chancellor Rishi Sunak unveiled an additional package to help households facing an expected further rise in energy bills this autumn.
How will markets react?
Sue Noffke, head of UK equities, says: “The chancellor’s measures will offset some of the impact of higher energy prices later this year, particularly for the hardest hit UK households.
“The ‘squeezed middle’ is getting a little bit more help to muddle through and then we have the better off able to draw on savings accumulated during the pandemic. There’s a dichotomy in the market.
“So, we’re seeing discount retailers which offer value for money for the ‘have less’ holding up well while luxury sectors serving the ‘haves’ are also proving resilient.
“More broadly, the strongest companies may well increase their market share. And don’t forget valuations – the shares of many consumer discretionary companies are already discounting tougher times ahead.
“The de-ratings we have seen are somewhat indiscriminate, affecting both companies whose earnings have proven resilient as well those in the more exposed sub sectors.”
Jean Roche, UK mid cap fund manager, says: “Household goods spend tends to be more resilient than, say, clothing in a downturn.
“At the moment, we can see this sub sector holding up well in retail sales data, despite the dire headlines.
“Strong demand for both new and second hand homes, as well as ongoing working from home trends are supporting the sub-sector.
“Meanwhile, don’t forget UK households overall have accumulated c.£200 billion of excess savings over the last two years.”
UK interest rates: current position and forecast
The Bank of England (BoE) raised UK base interest rates – the so-called "Bank Rate" – from 0.75% to 1% at the start of May.
At the same time, it published market expectations for where rates might be heading, as shown below.
Compared to February when the BoE conducted the same exercise (see the dotted line), the Bank Rate is expected - on average - to be around one percentage point higher over the next three years.
Higher rates of course mean higher borrowing costs. The move is designed to dampen economic activity by reducing consumer demand for goods and services, as well as the amount companies spend and invest.
Our economists here at Schroders currently see UK base rates rising to 2.25% in the first quarter of 2023 – more than twice their present level.
Super-high interest rates: will a re-run of the 1970s be avoided?
Given the current inflation problem, the central bank may need to keep raising rates even at risk of economic activity. The cost of not taking action could be a situation not seen since the 1970s, when the only way to bring inflation back under control was to aggressively raise interest rates and cause a very deep recession.
Scroll down for a description of what happened in many Western economies during the 1970s, and how “stagflation” was eventually resolved.
"After much dithering, policymakers at the Bank of England appear to have decided that interest rates need to rise significantly in order to tackle inflation, even if it means tipping the economy into recession", said Azad Zangana, senior European Economist and Strategist.
“They will, of course, want to avoid a recession, but even with its own forecast, the BoE has inflation peaking at around 10% at the end of the year, and the economy contracting. It will hope that it can reduce domestic demand and ease wage pressures without causing too much damage to the economy.”
The BoE’s 10% peak annual consumer price inflation forecast is causing understandable alarm and its governor Andrew Bailey has described food supplies currently trapped at port in Ukraine as a “major concern”. But this headline rate is not the one most occupying the thoughts of economists. They are focused on “core” inflation in the economy, and what’s driving it.
Getting to the “core” of inflation
By stripping out volatile items such as oil and food, core inflation gives a clearer picture of underlying price trends. Core items include essentials such as education, telecoms and healthcare costs, as well as “discretionary” or non-essential items, such as meals in restaurants and other entertainment costs.
Without careful economic management, there is a risk we could see round after round of wage and price rises of core items resulting in destabilising “wage price spirals”. Here, expectations of inflation become a self-fulfilling prophesy. Prices climb – or become “unanchored” – as a result.
“The main risk for the UK economy is that the largely external price shock caused by higher energy prices causes domestic prices to respond, followed by wages,” said Zangana. “To some extent, we are already seeing evidence of this occurring.”
When does the Bank of England next meet to decide on interest rates?
The next key date for UK interest rates will be 16 June when the BoE’s Monetary Policy Committee (MPC) convenes again to debate further changes in the Bank Rate.
The UK labour market is currently “tight”, meaning unemployment is low and there are many job vacancies that companies are struggling to fill. This is due to a variety of reasons, a number of them related to the pandemic, which have prompted some workers to withdraw from work.
The latest data show that for the first time on record there are more unfilled job vacancies in the UK than unemployed people available to fill those jobs.
“In the past, higher demand for labour would have been met by migrants, particularly from the EU,” said Zangana. “Covid can take some responsibility for the recent slowdown in immigration, in addition to Brexit. This is making it easier for domestic workers to demand higher wages. The risk of course is that higher wage growth leads to ongoing strong demand, and further inflation.”
“After one member of the MPC voted to not raise rates at all in the March rate-setting meeting, three members voted for a half-point increase in the Bank Rate in May,” said Zangana. “Despite their hawkish rhetoric, we doubt that policymakers will actually hike the economy into recession.”
Five key questions about interest rates answered
Why have interest rates been rising?
In December 2021, the BoE became the first central bank of a G7 economy to raise interest rates since the pandemic. This formally began the process of these major industrialised nations “normalising” base rates, or “monetary policy”, from the emergency settings introduced in response to Covid-19, when they were cut close to zero to support economic activity.
As vaccines were deployed, economies re-opened and demand for good and services reignited. However, there have been shortages of materials, energy and transport due to Covid disruptions. This has resulted in delays, increased costs for producers of goods and services, and fed through into higher consumer prices, as tracked by the Consumer Prices Index (CPI) in the UK.
Covid is also continuing to play a role through the recent mass lockdowns in China, while Russia’s invasion of Ukraine is disrupting energy and food markets.
Why do higher interest rates matter?
On the assumption that inflation will eventually be tamed, monetary policy normalisation has driven up long-term return expectations for interest rates in real (adjusted for inflation) terms. During the closing months of 2021, markets began to price in higher base rates (reflected in higher rates on government bonds,and deposit accounts) even before the central banks began actually raising rates.
For many years investors have become used to the idea that cash left on deposit will lose value in real terms. That is, the interest gleaned will not keep pace with inflation. By the end of 2021, however, the expected annual return over the next 30 years on sterling cash had crept 0.1% higher (to -0.3% per annum) than where it had stood at the end of 2020 (Schroders forecasts).
True, -0.3% is capable of reducing the real value of £100,000 today to something closer to £90,000 worth of equivalent goods and services three decades in the future. Still, it’s been a small step in a more positive direction for long-term savers. That is assuming central banks are increasing interest rates to restore so-called “price stability” and bring inflation back under control, but at what cost?
Could higher interest rates result in a recession?
The BoE has to essentially “tighten” monetary policy, including raising interest rates, to restore balance between demand and supply of goods and services. This is required to ease wage pressures and avoid a threatened “wage price spiral”, where inflation expectations become a self-fulfilling prophesy. There are, however, questions about whether inflation can be tamed with only gradual tightening to deliver a hoped-for soft economic landing without crashing the economy.
Parallels are being drawn with the 1970s – what happened then?
Experts say if policymakers are not careful, the country could end up in a situation akin to the 1970s. At that time inflation was only brought back under control after interest rates were aggressively increased at the cost of a very deep recession in the early 1980s.
Many of the world’s major economies suffered from a combination of slow growth and high inflation, or “stagflation” during the 1970s. Oil prices rose sharply due to external events (two oil shocks resulting from war and then revolution in the Middle East) and wages were rising in Western economies as they struggled to adjust to the new realities. Wage-price spirals resulted and prices became unanchored.
In the UK, this meant CPI inflation peaking at 24.5% in August 1975 as the country was enduring its second recession in two years. There were seemingly few solutions to a dismal decade which culminated in the so-called Winter of Discontent of 1978/79.
Then the second oil shock of 1979 coincided with some major political changes in the West, culminating in the UK with the election of a new Conservative government in May 1979. As part of these changes, “monetarist” policies were adopted and interest rates were increased by 5% within six months, from 12% to 17% (the high in the period since 1950) which was maintained until July 1980.
UK inflation subsequently began a very long retreat, from a second peak of 17.8% in May 1980. The missed opportunities of the 1970s, however, arguably, came at the greater cost later to an economy forced into a deep recession, with millions left unemployed.
What is quantitative tightening (QT)?
All major central banks deployed unconventional policies in the wake of the global financial crisis of 2008, when conventional ones such as cutting interest rates were exhausted. They then reactivated these programmes in response to pandemic-related economic shutdowns. Most have either ended these schemes, or are poised to reverse them.
Central banks have accumulated large quantities of government bonds under quantitative easing (QE) programmes – the purchase of such bonds was used to inject money directly into the financial system and lower the cost of borrowing for households and businesses. These bonds on their balance sheets now look set to be gradually run down; to be sold back into the market in a process of quantitative tightening, or QT, which will raise the cost of borrowing in the economy.
This article is issued by Cazenove Capital which is part of the Schroder Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements. All data contained within this document is sourced from Cazenove Capital unless otherwise stated.