All eyes are on the economy. In the autumn of 2021, we thought the economy was on track for a gradual recovery post-Covid, establishing a stable platform for house price growth. But the global surge in inflation caught most economists and policymakers off guard. Central banks have responded by raising interest rates to levels last seen at the time of the financial crisis of 2008-2009. Is this the beginning of a new chapter for interest rates?
The Bank of England is now forecasting that UK inflation may peak at 13.3% in the fourth quarter of 2022, and remain in double digits for most of 2023. The worry is that current inflation, which has been fuelled by the pandemic, supply chain disruption and war in Ukraine, risks becoming embedded as businesses pass higher costs onto consumers.
To reduce pressure on households, and to bring inflation back towards the 2.0% target, the Bank’s Monetary Policy Committee voted in August to raise the base rate to 1.75%. This was the sixth increase in nine months, taking rates to their highest level since 2008. This announcement came with a gloomy warning about the economic outlook. The Bank is forecasting that the economy will contract by 2.1% from peak to trough over the next 5 quarters. This suggests we are heading for a downturn similar to that of the 1990-92 recession, rather than the 5.9% drop in GDP seen in 2008. Note that this is unlikely to be a labour market induced recession. The jobs market is tight, which should mean that people remain in employment in the near term.
In August the Bank acted aggressively to help manage inflationary expectations, but it may not necessarily continue on this path. The financial markets expect the base rate to rise to just under 3.0% by the end of the year. However, we consider that several indicators give grounds for more optimism about the health of the economy in 2023, particularly if there is a fiscal boost later in the year. We think that raising the rate to about 2.5% could be sufficient to curb rising costs domestically. The outcome will, of course, also depend on inflation and monetary policy in the US and elsewhere.
We expect the base rate will be increased to 2.5% towards the end of this year, before falling again in late 2023 as inflationary pressures recede. Mortgage rates are likely to peak in the first half of 2023, putting another squeeze on households’ disposable incomes which have already been eaten away by surging food and fuel bills. The further rise in the energy cap expected in January 2023 means that the first half of next year is likely to be the toughest for households.
By 2024, inflation is forecast to return to near its 2.0% target, lifting the economy out of recession. But aftershocks seem set to trigger an increase in the rate of unemployment which could reach 4.75% in 2023, a level last seen in 2017. The current rate is 3.9%.
However, the Bank may become concerned that inflation could undershoot its target, making rate cuts necessary. We expect rates to begin falling towards the end of 2023, followed by a few further reductions in 2024, with the bank rate reaching 2.0% by the end of that year. Mortgage rates should also fall, as lenders’ borrowing costs decline, and wider economic uncertainty fades.
But the big question is: where will interest rates settle in the longer term? As a result of household indebtedness, people are more susceptible to interest rate rises than ever before. The level of mortgage repayments to household incomes means that a base rate of 2% today is equivalent to a rate of about 9% in the early 1990s.
This is the main reason why we think that interest rates will not move relentlessly upwards. Instead, by 2025, we think the base rate will settle at a new normal of around 1.75%, above the 0.6% average of the 2010s, but considerably lower than the 4.3% average of the previous decade.
