At its February 2023 Monetary Policy meeting, the Bank of England signalled the peak in the Bank rate had been reached.
What are the likely reasons for this? Ten interest rate hikes have taken the rate from 0.1% to 4%. The effect has been a housing market in sharp reverse, business failures beginning to rise, and an economy in recession. Borrowing costs have doubled or tripled for most households and businesses over the past year.
It’s no wonder retail sales are falling sharply, and living standards are dropping at their fastest rate since the 1950s. High inflation outside of their control has played a role in this. Rising energy and food prices because of the Russian invasion of Ukraine have significantly reduced living standards because there’s been an inflation-adjusted cut in the income of households because of inflation eroding their spending power.
The Bank of England still thinks the economy is heading for a recession and is forecasting that it will shrink by a quarter of a per cent this year and another quarter of a per cent next year, so little or no growth over the next two years. Chart 1 shows the banks’ forecast, with the economy flatlining for the next two years. Even in 2025, it expects meagre growth of 0.3%, with output still below its pre-COVID peak reached in Q4 2019.
One reason the Bank gives for temporarily lowering its forecast of UK output growth to just 0.7% for the next few years, is the after-effects of Brexit, poor productivity and COVID. The Bank thinks that trade and investment have been impacted by the UK leaving the EU.
The growth rate will not remain at 0.7%, thankfully. But the medium-term growth rate is more likely to be around the 1½% a year mark than the 2½% annual rise recorded before the global financial crisis of 2008 /9.
Moreover, the UK is performing worse compared to any of the other major developed economies, despite many facing the same challenges. As chart 2 shows, in its January economic 2023 update, the IMF predicted that the UK is the only G20 economy expected to see a contraction in output in 2023. It also leaves the UK as the only G7 economy not yet to surpass its post-COVID peak in output.
The only good news is that the decline is much less than expected as recently as November 2022, when the Bank was looking for a contraction of 2½% over 2023 and 2024.
A strong indicator of the view that rates may have peaked is that two members voted to hold rates at 3 1/2%, and no member voted for a rise of more than half a per cent. In the press conference, the Monetary Policy Committee (MPC) said they would only want higher rates if they saw persistent inflation pressures. On top of that, they expect inflation to fall quite quickly, dropping to under 4% in the final quarter of the year.
Looking at their forecast, consumer price inflation should drop below 1% by May 2024, well below the 2% target. That means, based on their forecasts, that the current level of the Bank rate has already more than achieved the job of pegging inflation at around 2%. That implies no need to raise interest rates any further. Indeed, if inflation were to fall more sharply than expected, it would mean cuts in interest rates, not hikes. In short, interest rates have peaked.
Circumstances could change this profile in either direction. If inflation were to spike higher, there would be more pressure to raise rates. But if inflation were to fall sharply or the economy declined even quicker, the incentive would have to be to consider rate cuts by the end of 2023 and early 2024. Even the financial markets are only looking for one more modest rise in UK rates, well down from expectations in late 2022.
For many, the robustness of the labour market is a concern, but that’s a red herring. Vacancies are high due to the number of unfilled jobs that are critical in the hospitality sector, in construction, and in the health service. These are not related to the economic cycle and are not an indication of an overheating economy.
If anything, they indicate any economy whose supply side is damaged and the effects of an ageing population. True, if these jobs were filled, the economy would grow more quickly, which might be a reason for concern if demand were too high. But that’s far from the current problem for the UK economy. In the current circumstances, these jobs are crucial to maintaining living standards. Instead, they illustrate that something is badly awry in the economy with severe deficiencies across a range of sectors, which everyone has felt the effects of in the quality of their lives.
So, my conclusion is that the Bank rate has peaked, and that, barring an unforeseen spike in inflation, the next big move in interest rates ought to be down, not up.