22 June 2022
Today’s 75 basis points (bps) rise in interest rates might be the largest in 33 years and takes interest rates to 3%, the highest level since 2008. However, the commentary that accompanied that decision was decidedly dovish. This suggests that while there would be more rate rises coming, they wouldn’t be as big, or as many as the financial market was expecting. As a result, we are maintaining our view that peak rate is likely to be closer to 4% than 5%.
In a three-way split decision, the Monetary Policy Committee (MPC) voted to raise the benchmark rate to 3.0% from 2.25%, despite the MPC saying it thinks the economy is already in a recession. One member voted for a 25bps increase, another called for a 50bps hike, but the majority of the committee went for a 75bps rise.
Middle market businesses should brace themselves for an extended period of shrinking and weak demand, rapidly rising energy costs and higher interest rates.
A protracted recession
The Bank’s forecasts for GDP indicate it is expecting a protracted recession. It thinks that if interest rates follow the path expected by markets (a rise to 5.25% early next year) then the economy will be in a recession until the second half of 2024 and GDP will fall by almost 3%. Admittedly, markets now expect rates to peak at around 4.75% so this forecast might overstate the fall in GDP. But the Bank hasn’t taken the likely upcoming austerity into account, which would worsen the forecast. Overall, a drop in GDP of between 2% and 3% seems reasonable to us.
The recession will lead to inflation falling sharply over the next year. The MPC predicts that CPI inflation will decline to 2.2% in two years’ time if Bank Rate is maintained at 3% indefinitely, but will fall to 1.4% if Bank Rate is increased to 5.25% next year, as financial markets expect.
The standout quote in the report was this:
“The majority of the Committee judges that, should the economy evolve broadly in line with the latest Monetary Policy Report projections, further increases in Bank Rate may be required for a sustainable return of inflation to target, albeit to a peak lower than priced into financial markets.”
Translating this from Central Bank language equates to, if the economy is in as deep a recession as the MPC thinks it is, then the MPC will only need to raise interest rates a little bit further and certainly not to the 5.25% financial markets expect.
So, the message is that rates will have to go a little bit higher to get inflation down to 2% but no where near as high as 5.25%.
However, it’s worth remembering that the MPCs ultimate decision will be driven by the data in front of them. Indeed, it caveated its push back on how high interest rates will go by saying, “there are, however, considerable uncertainties around the outlook. The Committee continues to judge that, if the outlook suggests more persistent inflationary pressures, it will respond forcefully, as necessary.” This gives it plenty of flexibility to respond to the latest data and doesn’t rule out further large rises in interest rates.
The degree of fiscal tightening announced in the Autumn statement will be a big factor in how much interest rates are raised in December. All else being equal, tighter fiscal policy requires a looser stance from monetary policy.
Our expectation is that the prospect of fiscal tightening and the deteriorating economic outlook will give the committee reason to slow the pace of rate hikes further ahead. We see a 50bp move in December with a step down to 25bp in February 2023. But we also doubt the committee will be willing to stop hiking until its clear that the labour market is easing and core inflation is falling, that might not be until the middle of next year.
As a result, we still expect rates to peak at around 4.5% early next year. However, it will probably be Q2 2024 before interest rates start to be cut as favourable base effects and weak demand see inflation drop below 2%.