Members of the Bank of England Monetary Policy Committee (MPC) have had more than enough to discuss over the last three or four years. Rising energy prices, inflation, Covid and the Ukraine crisis, not to mention the ongoing uncertainty surrounding Brexit, have created a potent monetary policy mix. Then we had the recent autumn statement, dubbed the mini-budget, in September, which crashed the pound, caused enormous problems for pension funds, increased borrowing rates and cost UK taxpayers billions of pounds in debt interest charges.
Against this backdrop, it is easy to overlook statements from the Bank of England concerning UK interest rates in the short to medium term. So where do we stand now, and what are the prospects for 2023 and beyond?
Recent interest rate rises
UK interest rates bottomed out at 0.1% on 19 March 2020, with the global economy effectively shut down due to the Covid pandemic. The Bank of England maintained this rate until 16 December 2021. Since then, we have seen several rate hikes:
- 16 December 2021, rate increased to 0.25%
- 3 February 2022, rate increased to 0.50%
- 17 March 2022, rate increased to 0.75%
- 5 May 2022, rate increased to 1.00%
- 16 June 2022, rate increased to 1.25%
- 4 August 2022, rate increased to 1.75%
- 22 September 2022, rate increased to 2.25%
- 3 November 2022, rate increased to 3.00%
- 15 December 2022, rate increased to 3.50%
In summary, UK interest rates have increased by 3.40 basis points between 15 December 2021 and January 2023.
As the global economy began to reopen, a mixture of pent-up demand and supply chain issues prompted a significant increase in inflation. However, many believe that the Bank of England, having mentioned the threat of higher inflation in many MPC meeting notes, was too slow to react. Until recently, the consensus was that the Bank of England was playing catch-up with the ECB and the US Fed, but times are changing.
So what do Andrew Bailey, Governor of the Bank of England, Huw Pill, chief economist, and the rest of the MPC members expect for UK interest rates in the short term?
UK economic outlook
Before we look forward to forecasts for the UK economy, it might be helpful to look back at the recent performance compared to the Eurozone and other leading economies.
As you can see, while the UK economy was relatively strong compared to others in the final quarter of 2021 and the first quarter of 2022, GDP growth has since plummeted. As a result, UK GDP has gone from a position of relative strength to the weakest economy in the third quarter of 2022. Consequently, the UK has been the worst performing by a significant margin when looking at economic performance pre-pandemic to date.
Towards the middle of 2022, there was speculation that the UK economy was approaching a recession, if not already in recession. However, some of the economic data on which these forecasts were based proved to be overly pessimistic and were the subject of upward revisions. While this prompted a sigh of relief, there are serious concerns that the UK is fast approaching a technical recession.
What is a technical recession?
In the coming months, you will probably hear much mention of a technical recession, defined as an economy with negative growth in two consecutive quarters. Until recently, the Bank of England was expecting the final quarter of 2022 to show a decline in GDP of around 0.3%. However, the value of this earlier forecast has yet again been called into question when the Bank of England adjusted expectations to a fall of just 0.1%.
As it happens, GDP in the final quarter of 2022 remained positive, so the UK is not technically in recession. However, in reality, the UK is in a full-blown recession, with further pain likely as interest rates continue to rise to combat inflation. The Bank of England MPC is expected to increase base rates in the short to medium term, although there is speculation about the rate of increase.
While the recent increase in base rates is starting to impact the rate of inflation, there are concerns about the prospects for the UK economy in 2023 and beyond. A recent article in the Financial Times highlighted short-term challenges for the UK economy compared to its peers. The consensus is that UK GDP will fall by 1% during 2023, compared to just 0.1% for the Eurozone and 0.25% for the USA. Moreover, due to high exposure to energy prices, an extremely tight employment market and mortgage renewals impacting the housing market, the UK is expected to underperform for some time.
To put this into perspective, according to research by Capital Group, historically, the average recession lasts just ten months, with the average period of expansion lasting 69 months. At this moment, the UK is potentially exposed to an extended slowdown which will strongly influence short to medium-term interest rate movements.
UK rate of inflation
Over the last 12 months, the annual inflation rate in the UK increased from 5.4% to a peak of 11.1% in October 2022. However, the pace slowed slightly in November 2022, standing at 10.7% and falling to 10.5% in December. We await the January figure with anticipation. So while there is some cause for hope with the January inflation rate, what should we expect over the next 12 months?
Prime Minister Rishi Sunak recently delivered a speech in which he promised to reduce inflation (measured by the Consumer Price Index) by 50% in 2023. This would suggest a rate of around 5%, which appears a little optimistic at this moment in time. However, the Bank of England has also become slightly more confident about the fight against inflation. The MPC expects UK inflation to fall to between 5% and 6% by the end of 2023. However, economists believe that UK inflation could end 2023 as high as 7%. Who will be proved correct?
Recent data suggests that the Bank of England has “broken the back” of inflation, but there may still be some flies in the ointment. In the short to medium term, several factors could put further upward pressure on the rate of inflation, including:-
- Inflation-busting public sector wage agreements
- Further upward pressure on energy prices
- Pressure on wage inflation due to the tight employment market
- An extended Ukraine/Russia conflict maintaining pressure on energy bills
While it is unlikely that inflation will register double-digits any time in 2023, there is still a lot of uncertainty on a regional and global basis. Therefore, looking further down the line, we could see further reductions and inflation fall below the BOE’s target rate of 2% by mid-2024. This would be a considerable achievement, but at what cost to the economy?
As the UK economy began to slow in the latter part of 2022, there was significant downward pressure on exchange rates. This pressure ramped up dramatically in light of autumn’s disastrous mini-budget, which increased government borrowing costs, prompted concern amongst lenders, and caused severe liquidity issues in the pension industry. While much of the uncosted elements of the mini-budget have been reversed by Jeremy Hunt, there is no doubt this has caused significant reputational damage to the UK government and, by association, the Bank of England.
On a more positive note, there has been a recent recovery in sterling, with many economists expecting further positive movement against both the dollar and the euro during 2023. This is crucial in the fight against inflation, as a strong pound reduces imported inflationary pressure but will negatively impact export growth. In addition, money markets are also watching ongoing wage negotiations between the government, businesses and various unions, which may result in agreements which will fuel inflation.
It is fair to say that last year was not the easiest time for the UK government or the Bank of England. There has been significant reputational damage to both bodies, and it may take some time for financial markets to regain confidence.
The Liz Truss’ government attempted to inject a positive tone with the autumn budget but went too far, too quickly, with uncosted promises. Three Prime Ministers in just a matter of months, a disastrous budget which was reversed, a significant increase in borrowing costs and the cost of living crisis have not instilled confidence. Even now, many believe that the current Prime Minister will not remain in office for too long, and we may see a general election sooner rather than later. More political uncertainty!
Even though the Bank of England now seems to be taking a more “sensible” approach to inflation and interest rates, late 2022 and early 2023 were challenging times. Even the MPC now recognises that it underestimated the threat of inflation and that interest rates should have increased earlier. This reluctance to act earlier has extended the probable peak in rates in 2023 with a knock-on effect on borrowing costs and mortgage rates.
The December MPC meeting, which resulted in a 0.5% increase in base rates, showed a growing difference of opinion. Minutes from the event show a majority of 6 – 3 in favour of increasing base rates. Two members voted to retain the rate at 3%, while one member favoured a 0.75% increase to 3.75%. There are significant differences of opinion regarding how best to combat inflation and the cost of living crisis. What can we expect going forward?
A few weeks ago, the consensus was that UK base rates would likely peak at 5% during 2023. While most economists have reduced their expectations in recent weeks, finding a consensus is difficult. For example, current market expectations are as follows:
- The Bank of England doesn’t believe that rates will hit 5% during 2023, but there was a degree of uncertainty with this forecast
- Deutsche Bank now expects base rates to peak at 4.5% in May 2023, against previous expectations of 4.75%
- Credit rating agency Fitch recently increased its peak forecast for UK base rates by 150 basis points; this now stands at 4.75%
- Investment analysts at AJ Bell expect rates to peak at around 4.5% (a working assumption)
This is just a selection of the varying views in the market concerning UK base rates and expectations for 2023. On the surface, this uncertainty regarding the potential peak would suggest that the fight against inflation is proving a little more successful than assumed just a few weeks ago. However, there may yet be one more fly in the ointment!
While highly unlikely and seen by many as just a passing comment, one member of the MPC recently suggested UK base rates could fall in the short term. In a wake-up call for UK investors, consideration has been given to whether UK economic performance in 2023 could be even worse than current expectations. It is not inconceivable that UK base rates may fall at some point if the economy was to nosedive. While difficult to see such a scenario at the moment, again, this passing comment perfectly illustrates the challenges facing the MPC and the uncertainty surrounding the UK economy. Dare we even consider looking towards next year and the prospects for recovery?
Despite making mistakes in the early days, the Bank of England now seems to have a handle on inflation. A growing number of experts now believe inflation may have peaked. Slowly but surely, the forecast peak for the base rate in 2023 is falling. Of course, there is still some uncertainty and differences of opinion, but the trend is most definitely downwards.
The fight against inflation via increased base rates is detrimental to the economy. Unfortunately, in the short to medium term, the UK economy is set to struggle and underperform many of its peers. While recent years have shown that economic expectations can turn on a sixpence, reputational damage and the rate of inflation don’t bode well for short-term prospects. So who would be a member of the MPC?