End in sight for interest rate hikes

As the summer ended, signs began to emerge that the battle to curb inflation by raising interest rates was being won. William Morris CFA, Head of Investments at Weatherbys Private Bank, sat down with Paul Dales, Chief UK Economist at Capital Economics, to discuss whether central banks have done enough, and whether they will now call time on the flurry of interest rate hikes that have encapsulated the year so far.

Watch the full recording…

Read the highlights…

Have interest rates peaked?

I sense that we’re starting to see a greater body of evidence that suggests higher interest rates are working, by dampening economic activity and employment growth. This will eventually result in slower core inflation and wage growth, which is why we think rates have peaked in the UK, US and Europe.

Will the rising price of crude oil throw a spanner in the works by fuelling inflation?

If the oil price were to stay at its current level of around $90 to $100 per barrel, then inflation would fall more slowly than we previously anticipated. However, when it comes to the UK, the drop in utility prices is having the biggest effect on falling inflation, and we continue to believe that it will fall to 5 per cent by the end of the year.

For our outlook to be very different, the price of oil would need to jump to $150 per barrel. And even if that were to happen, inflation could still fall, although central banks would likely keep interest rates at their current peaks for longer than planned.

Do you think that interest rates will stay, as the ubiquitous phrase goes, ‘higher for longer’?

I don’t think this will be the case in the US, because inflation looks likely to fall to its 2 per cent target much earlier than most people expect. On the other hand, the UK has a bigger inflation problem, partly because of stickier domestic inflation driven by a reduction in the supply of labour, which has boosted the rate of wage growth more than in the US. Strikes and big public sector pay deals have exacerbated matters.

So, while we expect the Fed to cut interest rates in the first half of next year, we don’t believe the Bank of England will be in a position to do so until the end of 2024.

When central banks do reduce rates, will it be just a few token cuts?

No, we believe the cuts will be more drastic than many are anticipating. The markets are pricing in rates of between 4 and 5 per cent in the UK at the end of 2025. Our view is that if the UK enters a mild recession, inflation will come down quite significantly. The Bank of England will then be able to declare victory and plan on making bigger cuts to around 3 per cent by the end of 2025.

Where do you think interest rates will settle in the long run?

We don’t envisage returning to a world of almost zero rates, but neither do we think we are going back to the interest rates that preceded the financial crisis. The norm will be somewhere in between. Before the pandemic, we thought that the so-called neutral interest rate in the UK would be about 2.5 per cent. Now, we believe rates will more likely settle at around 3.5 per cent.

Will the housing market weakness continue?

In our view, mortgage rates are going to remain in the region of around 5 to 6 per cent for the best part of another 18 months, which is high compared to the past few years. This cumulative effect will gradually take its toll on the housing market, so further weakness can be expected. Prices have already fallen by around 6 per cent from their peak a year ago, and we suspect they will fall by a similar amount over the next year or so, too.

How will AI affect productivity and employment?

We believe that generative artificial intelligence (AI) is a transformative technology that is going to filter throughout the whole economy and give a significant boost to productivity growth. The UK has had very poor productivity for the past decade, but we believe that AI could change that.

In the past, major technological revolutions have taken place in the industrial and agricultural sectors; this time it could be the turn of the services sector. And the UK has a big services sector where businesses can meaningfully innovate, adapt and adopt AI. Our analysis suggests that the US is going to be the winner from the AI revolution with the UK not far behind.

Naturally, some jobs will be lost to AI, but some will be complemented by it, and many will be created. And if AI boosts productivity, as we believe it will, it will generate a bigger economy and stimulate employment growth.

Weatherbys’ view

Ultimately, long-term changes in share prices have little to do with the caprices of economic sentiment over the short term. They have much more to do with innovation, invention and problem-solving – and AI could yet play a pivotal role.

However, we would caution against trying to pick specific winners. Some companies have done very well from AI-related speculation already, but it is plausible that the creative adopters of this technology will generate the most value in the years to come. And nobody can predict the future – not even the inventors themselves!

Instead, we engineer investment portfolios according to sound philosophical foundations – relying not on past performance or future prophecy, but fallibilism and good explanations.

As ever, we remain at your disposal to solve whatever financial quandaries may be weighing on your mind.

Important information
Capital Economics is an independent consultancy firm. Past performance is not a guide to future returns. Please note that the value of investments can go down as well as up, and you may get back less than you originally invested.