UK interest rate outlook

The war in the Middle East has rewritten the future path for UK inflation and interest rates. In mid-February inflation was on course to return to its 2.0% target rate, and financial markets expected the Bank of England to cut interest rates from 3.75% to 3.25% by the end of the year.

Higher energy prices pushed inflation from 3.0% in February to 3.3% in March. On the Bank’s most optimistic forecast scenario UK inflation will now peak at around 3.6% at the end of this year. Its most severe scenario, of persistently elevated energy prices creating a wage price spiral, sees inflation peaking at 6.2% early next year.

No wonder financial markets assume that, far from cutting rates, the Bank will raise them by 25bp in July and again in September, taking them from 3.75% to 4.25% at the end of the year, 100bp higher than expected in early February.

Economic forecasts and market pricing warrant attention but are often wrong. The Bank of England’s latest Monetary Policy Report (MPR), published last week, provides a skilful analysis of the outlook and the risks, but the Bank can no more predict the impact of this energy shock than the one following the invasion of Ukraine in 2022.

The Bank underestimated the scale and the persistence of that episode, and it seems determined to avoid repeating the mistake. The Bank is clear that it can do nothing to mitigate the initial impact of higher energy prices. Its focus is on second-round effects, with the risk that higher energy prices fuel wage pressures and encourage firms to raise prices.

Whether such second-round effects materialise will depend on underlying strength of activity across the economy.

In early 2022 the UK economy was running hot as the economy bounced back from the pandemic, with inflation and wages on the rise and unemployment close to an all-time low. An abrupt rise in energy costs, coming at a time of strong growth, triggered sizeable and persistent second-round effects that took inflation to a peak of 11.1%.

The backdrop today is quite different. With the exception of a strong first quarter, which looks like a one-off, growth in the last year has been subdued. Inflation and wage pressures have been easing while unemployment has risen and is above the levels that have prevailed for most of the last ten years.

Higher energy costs have already driven up mortgage costs and rates on lending to corporates. Higher borrowing costs, coupled with a squeeze on spending power caused by higher energy prices, will tend to depress growth.

A weak jobs market gives workers less scope than in 2022 to seek wage rises. According to the latest Deloitte CFO Survey, UK businesses have doubled down on cost reduction in the wake of the conflict in the Middle East while corporate hiring intentions have fallen to levels last seen in 2020 in the early days of the pandemic. Consumers have become more concerned about inflation and worry that it may be here to stay. But their ability to compensate by pushing through offsetting wage rises appears to be limited.

The Bank seems more concerned that firms will respond to higher inflation by raising their prices. Profit margins are narrower than in 2022 giving firms less scope to absorb higher prices. The surge in inflation after the pandemic means corporates are more sensitive to inflation and are changing prices more frequently than in the past. The Bank’s latest Decision Maker Panel survey shows that 64% of firms expect to increase prices over the next year in response to higher energy costs.

Where does this leave prospects for UK interest rates?

Even the Bank’s relatively benign forecast scenarios suggest the need for rates to rise by perhaps 50bp this year. Financial markets have priced in exactly this outcome. However, the Bank’s governor, Andrew Bailey, challenged such notions in an interview after the release of the MPR last week when he said, “I would caution against reaching any strong conclusions about us raising interest rates”.

I agree. My guess is that this energy shock will dampen growth and, once the initial impact of higher energy prices abates, inflation will fall back. Rate hikes are not yet a done deal.