21 September 2023
Today’s decision to hold interest rates at 5.25% means they have already peaked – we’ve been strolling along the top of Table Mountain without knowing it. Attention will now inevitably turn to when interest rates will start to be cut. However, inflation is likely to remain sticky over the next year, meaning rates will remain their current levels for around a year and even then, rates are only likely to come down gradually.
A hawkish pause
Economic data has weakened across the board over the last few months, with the exception of wage growth, which remains exceptionally high. However, it is probably just a matter of time before the recent weakness in the labour market feeds through into lower wage growth. All this appears to have been enough to convince five of the nine Monetary Policy Committee (MPC) members that rates are already high enough to bring inflation down sustainably. The other four members voted for a 25 basis points (bps) hike.
The MPC was keen to stress to financial markets that interest rates are likely to stay at current levels for an extended period now. The statement did not say that rates have peaked and with such a small margin voting for a ‘no hike’ it wouldn’t be hard to see the committee voting to hike rates again if inflation starts to look sticky.
What’s more, the minutes repeated the line that if there was evidence of more persistent inflation pressures “further tightening in policy would be required”. And it retained the hawkish guidance that rates will stay “sufficiently restrictive for sufficiently long”.
Afterall, the main concern of the MPC is that financial markets start pricing in significant rate cuts that loosen financial conditions and let inflation back off the leash.
Finally, the MPC voted unanimously to target a £100b reduction in the Asset Purchase Facility over the next 12 months. That’s similar to the reduction over the last year and probably won’t have much impact on gilt yields.
We can’t rule out another rate hike in November, in the same way that the Fed paused in June then raised again in July. There are a dozen reasons why inflation might not fall as quickly as expected from rising energy prices to stubborn wage growth. But we think by the next meeting in November economic conditions will have continued to move in the MPC’s favour and wage growth will have eased materially.
Afterall, we estimate that only a little over half of the full impact from the previous rise in interest rates has come through to the real economy so far. That means there is still a big drag on the economy to come. And as inflation falls, real interest rates will rise, increasing the drag on the economy without the MPC having to raise rates further. We aren’t forecasting a recession, but with precious little growth over the next year it wouldn’t take much to tip the economy into one. As a result, we think patience was the correct decision from the MPC.
However, sticky core inflation will mean that the MPC won’t start cutting rates until this time next year and even then, rates are only likely to come down gradually. We expect interest rates to finish 2024 at around 4.75%.