24 March 2023
Today’s 25-basis points (bps) hike takes interest rates to 4.25%, the highest level in 15 years. There are good reasons to think that this is now the peak – the Monetary Policy Committee (MPC) reiterated that it will need to be surprised by the economic data in order to raise rates further. What’s more, the tightening in financial conditions as a result of the recent turmoil in financial markets is equivalent to around 25-bps of policy tightening according to our calculations, reducing the need for further rate hikes.
However, the economy has proved much more resilient than expected and the labour market remains stubbornly tight. If the labour market hasn’t eased significantly by the summer then the there is a risk that the MPC will have to resume rate hikes later this year.
So, there is room for one more rate hike, but only if the labour market continues to defy gravity. We think 4.25% will probably mark the peak for UK interest rates.
Financial conditions add to the confusion
The MPC addressed the recent turmoil in financial markets by confirming that the “UK banking system maintained robust capital and strong liquidity positions, and was well placed to continue supporting the economy in a wide range of economic scenarios, including in a period of higher interest rates.”
But the committee also noted that the banking turmoil posed an extra uncertainty to “the financial and economic outlook” and that it was monitoring credit conditions, which have the potential to play a key role in future decisions. Widening credit spreads makes it more expensive for corporations to borrow and so dampen activity in the economy, even if the base rate remains unchanged.
Based on our modelling, assuming the widening of corporate spreads seen since the start of the banking turmoil persists over Q2 2023, the recent tightening of credit conditions is equivalent to roughly one 25-bp hike.
Recent uptick in inflation suggests path to 2% will be bumpy but still steep
The MPC took the edge off the 25-bp hike in Bank Rate by downplaying the significance of the unexpected increase in CPI inflation in February. Indeed, it said it still expects inflation to fall sharply over the remainder of 2023 and that services inflation, which is more closely related to the domestic economy, is broadly in line with its expectations. It blamed most of the surprise jump in inflation on spikes in food prices, due to bad weather, and clothing prices, which tend to be volatile. It expects these types of inflation to be less persistent and so is less concerned about them.
We expect inflation to be around 3% by the end of this year and fall below the Bank’s 2% target in 2024, as the large falls in energy and shipping prices make themselves felt.
The MPC also kept its forward guidance from February, which was:
“The MPC will continue to monitor closely indications of persistent inflationary pressures, including the tightness of labour market conditions and the behaviour of wage growth and services inflation. If there were to be evidence of more persistent pressures, then further tightening in monetary policy would be required.”
Translating this from ‘Bank language’ this means - whether interest rates increase again in May depends on whether there is evidence that the labour market is easing. It will also need to be sure that the spike in inflation in February really was a one off.
But assuming the economy evolves largely as we and the Bank of England (BoE) expects, then there is probably little need for further hikes.
Even with the economy struggling, we doubt the BoE will be comfortable cutting rates until inflation is within touching distance of the 2% target. In our forecasts, that doesn’t happen until Q2 2024. We have assumed cuts of 25-bps a quarter from that point until the end of 2025, when interest rates may feel a bit friendlier again.