Five common questions on interest rates answered

The huge surge in interest rate expectations this year – especially over the last few weeks – has pushed interest rates to the top of many boardroom agendas.

Here are the answers to the five most common questions we’re asked about why interest rates are rising, how high they’ll go, the impact on the economy and the housing market, and how long we think rates will stay high.

1. Why are interest rates rising, when it’s energy prices that are driving inflation?

Most of the increase in inflation is the result of rising energy prices, and no amount of interest rate rises will produce more natural gas or electricity. Why, then, is the Bank of England so insistent on raising interest rates to push inflation back down?

The expectation is that inflation will hit 11% in October. While it’s true that energy prices will probably be directly responsible for about a third of that, there are three other reasons why the Bank of England feels the need to aggressively raise interest rates:

1. First, inflation expectations had started to drift and the Bank felt its credibility was under threat. If consumers and businesses expect inflation to be higher in the medium term they are likely to demand higher wages and set higher prices to compensate, leading to higher medium term inflation. Similarly, if consumers doubt that the Bank of England can easily get inflation back under control, they’re likely to start factoring higher inflation into their plans.
2. Second, the labour market is exceptionally tight. As a result, nominal wage growth is running at almost 6% y/y, more than twice the 3% level the Bank thinks is consistent with its 2% inflation target. This is especially worrisome for the Bank, because inflation driven by higher wages tends to be “sticky”. By raising interest rates, the Bank can also increase unemployment, take some of the heat out of the labour market, and reduce wage growth.
3. Third, the huge fiscal stimulus recently introduced by the government will, all other things being equal, mean that demand is stronger, the labour market is tighter, and inflation is higher in the medium term. Therefore, the Bank will have to rely on increasing interest rates to offset the impact on inflation of a looser fiscal policy.
   We estimate the Bank will need to raise rates by an additional 1% to offset the rise in fiscal spending. Indeed, the Bank’s statement after the not-so-mini Budget said, “The MPC will not hesitate to change interest rates by as much as needed to return inflation to the 2% target sustainably in the medium term”. What’s more, the recent fall in the pound will also push medium term inflation higher, and that will need to be offset by interest rate rises of another 0.5%.

2. How high will interest rates go, and how quickly will they get there?

Financial markets expect interest rates to peak at 5.5% by this time next year. This is down from the 6% they were expecting rates to peak at last week, but it’s still significantly above the 4% peak markets predicted in mid-September.

Most of the work required to get from 2.25% to 5.5% in a year is likely to happen at the start of the journey (ie be front loaded). Financial markets are expecting a 1ppt rise in November to be followed by another 1ppt point increase in December, which would take interest rates to 4.25% by the end of the year. The Bank of England may then return smaller rate rises at the start of 2023.

For what it’s worth, our view is that a peak of 5.5% is too high. At that level, many businesses and households would be struggling with debts, and that raises the danger of a sharp recession and a drop in house prices. We suspect a peak of closer to 4.75% is more realistic, but we certainly can’t rule out rates going higher.

3. What’s the impact on the economy?

The sharp rise in interest rates will almost certainly push the economy into a recession in 2023. Dramatically higher mortgage rates will increase the pressures on household budgets at the same time as they are being squeezed by a further rise in energy prices and inflation. This will reduce consumption and sap demand. It will also add to firm’s costs.

In fact, 77% of the stock of private non-financial corporations’ bank loans is floating rate. Most of the remainder is fixed for less than two years. In addition, the stock of bank loans equates to three times businesses’ annual profits, so refinancing at considerably higher interest rates will eat into profits.

We expect higher interest rates to reduce business investment by about 3% in 2023. Our Middle Market Business Index found that middle market firms had already significantly scaled back their investment intentions, with just 34% of firms saying they are investing more.

This is understandable – but it does nothing to address the fact that the UK has the lowest business investment in the G7. For example, UK business investment is still almost 10% below its 2016 level compared to business investment in the US, where it is almost 25% above it. Lack of investment is a key factor in the UK’s poor productivity growth over the last decade.

Overall, we estimate that raising rates from 0.25% at the start of the year to 5% by the end of Q1 2023 will knock 0.5% of GDP growth in 2022 and 1% in 2023. Admittedly, as some of these interest rate rises are to offset the increase in fiscal spending, the net effect from interest rate rises and higher fiscal spending on the economy won’t be that bad. But we are still expecting the economy to contract in 2023 by about 1.5% due to the combination of the energy crisis and soaring interest rates.

4. How about house prices?

The crucial two-year fixed mortgage has already risen above 6%, compared to about 1% at the beginning of the year. This makes it inevitable that house prices will fall; we estimate a 10% to 15% drop over the next year.

It’s also likely that the cost of servicing a two-year fixed-rate mortgage on an average-priced home will rise to about £1,325 per month, from £725 in 2021. That’s likely to stretch affordability for many, and cause some prospective buyers to pull out of purchases – hitting demand. For many, the savings made from the recent stamp duty cut (a property tax) is likely to pale in significance against the cost-of-borrowing increase.

However, this has to be seen in the context of a 25% rise since the start of the pandemic, so there probably aren’t many homes with negative equity. Similarly, the exceptionally tight labour market means that the unemployment rate is unlikely to surge, and there won’t be a wave of forced selling.

This means we’re not expecting a house price crash. The drop in prices we’re expecting comes from a sharp drop in buyers and affordability, rather than a sharp increase in foreclosures.

5. When will the Bank start cutting?

By mid-2023, inflation should have fallen materially from its peak, house prices will be dropping, and the economy will probably be entering another recession.

As a result, the Bank is likely to finish its tightening cycle in the first or second quarter of next year. It may be a little while after that before the Bank starts to think about cutting interest rates. Specifically, it will want to see evidence that inflation has sustainably fallen back to the 2% target, which really means that wage growth will have to come back down to around 3% y/y. That probably won’t be until late 2023, or even early 2024. As such, we aren’t expecting the Bank to start cutting interest rates again until sometime in mid-2024.

Eventually, we think interest rates will settle at around 3%.