Implementing its eighth consecutive rate hike, the Bank of England warned that the UK should be bracing for the longest recession since the 1920s – yet markets are pricing in further tightening as the Bank attempts to curb inflationary pressures.
“We’re entering a brave new world of higher interest rates, and that has huge ramifications for consumers, businesses, governments, and investors, especially after such an extended period of ultra-loose monetary policy, which has lulled everyone into a false sense of security,” commented AJ Bell head of investment analysis Laith Khalaf.
Nevertheless Khalaf sees “some nuggets of information” providing a ray of hope for debt-laden businesses and consumers.
“The market is currently expecting interest rates to peak at 5.25% next year, but on that assumption the Bank of England says inflation will fall to 0% in 2025, 2% below its target. Even assuming interest rates remain at 3%, CPI comes in around 1% below target in 2025.
“The implication is that markets have got ahead of themselves, have priced in too many interest rate hikes, and actually we are now approaching the top of the cycle. In its commentary the Bank says its rate-setters think rates will peak at a lower level than expected, though they still threaten to act forcefully if inflation proves sticky.”
This may be good news further down the line but the latest predictions are that the incoming squeeze on real incomes is going to cost the majority of households £800 a year, Sophie Lund-Yates, Lead Equity Analyst at Hargreaves Lansdown pointed out.
“The poorest 10% of these households are expected to be hit harder, because they spend a higher proportion of their monthly budget on utilities and food, where prices have been accelerating faster than other areas.”
The tight labour market creates significant inflationary pressure, even though the Bank of England sees price rises falling below 10% in the second quarter of next year, with the issues stemming from the sharp contraction in the UK labour force since just before Covid.”
Oliver Jones, asset allocation strategist at Rathbone Investment Management, added that the risk of inflation staying higher than the BoE expects “remains significant, despite the government’s recent swing from fiscal expansion to contraction.
“The BoE itself judges that the risks to its inflation projections are to the upside, with Governor Bailey in his press conference suggesting that these risks may be the largest in the history of the monetary policy committee.”
Jones also pointed to the tightness of the labour market. “A key problem is the lasting weakness in supply since the pandemic, with hundreds of thousands of workers dropping out of the labour force, many due to long-term sickness. With firms competing for a smaller pool of workers, wage growth has risen to 6%, higher than the BoE previously forecast. The ratio of unfilled job vacancies to workers is also still exceptionally high, and the unemployment rate is near its lowest in half a century.
“Households’ and firms’ inflation expectations are also worryingly high. The Citi/YouGov measure of households’ long-term expectations remains above 4%. And the BoE’s decision maker panel survey of businesses shows that they plan to keep increasing prices and wages at rapid rates (6.7% and 5.9%, respectively) in the coming year.”
Khalaf added: “The government’s fiscal policy is also a big piece of the jigsaw that is still missing and will probably serve to dampen the need for rate hikes. The new Chancellor is due to set out his plan to fill the estimated £50 billion black hole in the nation’s finances on 17 November, through a combination of tax rises and spending cuts. The Autumn Statement will therefore almost certainly squeeze some more juice out of the tank of the UK economy, meaning the Bank of England can pursue a more moderate path with monetary policy.”
While no-one “should count their chickens” at the current juncture, he added, “this report from the Bank of England at least hints at some light at the end of the tunnel when it comes to the cost of living crisis.
“But while inflation is projected to fall back rapidly, the cost to the economy is expected to be a prolonged recession. The nightmare scenario presented by interest rates rising in line with market expectations is that the economy shrinks for the next two years, and unemployment rises to 6.5% in 2025.
“It now seems evident the Bank would only be forced to tip the economy into such a parlous state if inflation turns out to be more persistent than currently anticipated. If the Bank were to maintain rates at 3%, the economy is projected to shrink in 2023 and pick up a little bit in 2024, with unemployment rising to just over 5%.
“As things stand, the reality is likely to sit somewhere between these two outcomes, with the Bank saying more interest rate hikes are needed, but not as many as predicted by the market. Either way, the UK economic picture is pretty bleak for the foreseeable future.”
