Higher interest rates – but for how long?

The Bank of England has raised interest rates to a 15-year high as its battle to curb inflation continues. William Morris CFA, Head of Investments at Weatherbys Private Bank, sits down with Paul Dales, Chief UK Economist at Capital Economics, to discuss whether the strategy is working.

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Before we turn to the UK, can you set the scene by establishing what’s going on in the US? Have interest rates peaked across the Atlantic?

I don’t think so – rate hikes may well have paused, but not peaked. It feels to me that inflation is still a bit too high for the Fed’s liking, which suggests that it will indeed raise interest rates further, taking the range to around 5.25/5.5 per cent.

Interest rate hikes take time to feed through into the economy, and some of the forward-looking activity indicators suggest that economic growth is slowing. This weakness is perhaps necessary to bring core inflation down – only when we see solid evidence of this will interest rates likely have peaked. My instinct is that the US will enter a relatively mild recession, but not a deep one.

Why is UK inflation still so high by contrast?

There are lots of similarities between what is happening in the US, the eurozone, and the UK. However, the factors driving inflation are more marked in the UK, ­and that is why the Bank of England felt compelled to act last month by raising interest rates to 5 per cent. Inflation just hasn’t come down as far, with UK CPI at 8.7 per cent compared to the eurozone (5.5 per cent) and the US (4.1 per cent).

The UK’s inflation problems can be found in the labour market where wage growth is much stronger – and it is this that is causing domestic inflation pressures to be greater in the UK than elsewhere.

What can the Bank of England do to bring inflation down?

The amount of aggregate supply in the UK economy has declined below the level of demand and it is this that has generated a burst of inflation. Ordinarily, to bring inflation down you just raise supply again by increasing the number of workers or increasing the amount of investment. That would be the painless way out. Inflation would just subside without any economic weakness or higher unemployment.

Unfortunately, it’s really hard to pull those levers quickly. Alternatively, you can bear down on demand by bringing it into line with supply to curb inflation. This requires some economic weakness, which means the Bank of England has to create conditions that are painful for some and painful for the overall economy.

It’s a choice between high inflation or high-interest rates. Like the Bank, I’d suggest a temporary increase in interest rates is the lesser of those two evils.

What is your outlook for interest rates in the UK?

We expect the bank to raise interest rates to 5.25 per cent at its next meeting in August – and they may yet go to 5.5 per cent. Once we get into the autumn, there should be clearer signs that the influence of higher interest rates is starting to come through.

We estimate that about 40 per cent of the increase in interest rates has been felt so far, which means there’s still 60 per cent to come through, and much of that will play out in the housing market as people adapt to higher mortgage rates.

When might interest rates fall?

We believe that interest rates will stay at their peak for a relatively long period. Historically, interest rates usually stay at a peak for just a few months, but this time it could be a year.

If, as we forecast, a recession loosens the labour market, weakens wage growth, and therefore controls core inflation by the end of 2024, maybe going into 2025, the Bank of England will be in a position to cut rates. Once we are in a stable economic environment, interest rates can come back down to 2.5 or 3 per cent.

What is the outlook for the UK housing market?

It is important to illustrate the size of the problem with mortgage rates now over 6 per cent. First-time buyers with a median income purchasing an average house could see their mortgage payments rise from 35 per cent of their monthly income to around 55 per cent.

And if you are already a homeowner with a fixed-rate mortgage expiring, then your monthly mortgage payments might jump by 50 per cent.

These are huge numbers to absorb, and some people are going to be hit hard. This will translate into lower housing activity, lower house prices, and eventually a weaker period of consumer spending in general.

For those jetting off on summer holidays, what are your thoughts on currencies?

Of all the forecasts economists make, currencies are the hardest! That said, the pound is getting an ‘interest rate boost’; it has strengthened against the dollar and euro because interest rates are expected to rise further in the UK.

However, there could well be a flight to safer assets such as the dollar if the US enters a recession. If that does happen, the pound might be caught in the crossfire and I wouldn’t be surprised if it weakened to around $1.15 against the US dollar by the end of the year.

Weatherbys view

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