Today’s 50 basis points (bps) hike takes interest rates to 4.0%, the highest level in 15 years. But the language in the minutes of the report suggests that the end is in sight for the Bank of England’s (BoE) tightening cycle.
Indeed, the Bank’s own forecasts show that even if interest rates stay at 4.0%, inflation will probably fall below the 2.0% target by the middle of 2024. However, the Monetary Policy Committee (MPC) is clearly worried that inflation will be stronger than forecast.
The takeaway is that if the economy evolves exactly in line with the Bank’s forecast and wage growth and services inflation start to show clear signs of easing over the next few months, then interest rates may not have to rise any higher. But the committee very much feels that the risks are skewed very heavily to inflation staying stronger. As a result, we’re sticking with our forecast of a 25bps rate hike in March making 4.25% the peak.
The stickiness of core inflation and the strength of the labour market means rate cuts aren’t likely to come until 2024.
Shallower recession and lower inflation
The good news is that the MPC significantly revised up its forecast for GDP growth. Admittedly, it still expects the economy to fall into recession this year. But it has reduced the scale of the contraction from 3% of GDP to just 1%. That would make this recession one of the mildest on record and about half the size of the early 1990s. It also now expects the unemployment rate to rise from 3.7% currently to 5% by the end of 2024, compared to a forecast of 6% in November.
However, business investment seems to be one of the key weak spots in the projections. Business investment is expected to be much worse than previously anticipated, shrinking 5.5% this year.
At the same time, the committee revised down its inflation forecasts. At first glance, that seems odd. A shallower recession and lower unemployment should lead to more inflation, not less. But it largely reflects the very sharp fall in energy prices over the last few months.
Where next for interest rates?
This is where it gets tricky. According to the Banks’ own forecasts it has already done enough to bring inflation sustainably down, to 2% by mid-2024. This was the reason two members of the committee voted to keep interest rates unchanged.
However, the committee clearly thinks that the risks are that inflation remains higher, saying “qualitatively, an inflation forecast that took into account these upside risks was judged to be much closer to the 2% target at the policy horizon...”. Indeed, the committee made explicit mention that it would need to see clear evidence of core inflation and wage growth coming down before it could declare victory. Both these measures have shown no sign of slipping yet.
This is the latest guidance in the MPC report:
“The extent to which domestic inflationary pressures ease will depend on the evolution of the economy, including the impact of the significant increases in Bank Rate so far. There are considerable uncertainties around the outlook. 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 March depends on whether there is evidence that the labour market is easing. And even if there isn’t, subsequent rate rises are likely to be smaller.
We doubt that there will be enough time between now and March for there to be clear signs that the labour market is easing, or core inflation is starting to trend down. As such, we expect another 25bps rise in March taking interest rates to 4.25%. That is where they are likely to peak.
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.