Will higher inflation cause a recession in the UK?

William Morris CFA, Head of Investments at Weatherbys Private Bank, sits down with Paul Dales, Chief UK Economist at Capital Economics, to discuss the prospects for inflation and whether central banks will continue to raise interest rates.

Key points

  • inflation is now set to peak at 11% this year but will fall slowly
  • interest rates are forecast to rise to 3% in the UK
  • any recession to be mild unless unemployment rises significantly
  • stock markets could still face a challenging few months…
  • …but the long-term rationale for investing remains intact

How high will inflation go?

Inflation in the UK is currently at a 40-year high of 9.1%, while in the US it stands at 8.6% and in the eurozone, 8.1%. To put that into context, all those economies target inflation at around 2%.

What is driving this inflation spike?

The initial rise in inflation was caused by a post-pandemic surge in demand coupled with severe supply constraints due to economic shuttering. The war in Ukraine has simply exacerbated these pressures. However, those global triggers have lately translated into increasingly domestic drivers.

Inflationary forces in the UK are being kindled by supply shortages of goods and workers, rather than soaring demand. Many households have spare cash, but they’re not rushing to spend it.

The key point is that the UK unemployment rate is very low with businesses struggling to find people to fill the vacant positions. This means they are having to pay more to attract and retain workers, which is spurring inflation.

Whereas the global factors that led to the initial spike in inflation felt like one-offs, the UK’s domestic factors might be becoming entrenched to a degree. This is why we don’t believe inflation will fall as quickly as we had previously thought.

If inflation is largely supply-driven, won’t raising interest rates just add to consumer burdens?

It’s true that raising interest rates will not increase the supply of goods, energy or workers. So, in this sense, central banks can not bring inflation down in the short term simply by raising rates. But they can temper economic demand, and this deters firms from raising prices as much as they might have done.

And by raising interest rates, central banks are also sending a signal to households and businesses that they are serious about getting inflation back down to 2%. This reduces people’s price and wage expectations.

If supply does increase again and the conditions are in place for lower inflation, then it will fall back to the 2% target level. Raising interest rates is not a silver bullet because it does hurt households, but it is the lesser of two evils as the alternative is to let inflation rip.

How high will interest rates rise?

I suspect that rates will rise higher than many people expect. We, as economists, talk about the so-called “neutral interest rate”. This is the rate when everything is perfectly balanced in the economy: enough supply, stable demand.

I think the neutral interest rate in the UK is now around 2.5%. So, if you want to get inflation down to the target 2%, interest rates need to be above that neutral rate, to put a dampener on economic activity.

Consequently, we’ve recently increased some of our rate forecasts. We expect interest rates in the UK to rise from 1.25% to 3% to squeeze inflation out of the system. However, we do not think we will need anything like the double-digit interest rates of the 1980s to bring inflation back down.

Will the UK fall into recession?

The prospect is higher than it has been for some time. Indeed, the UK is already close to a recession because the high rate of inflation is reducing the spending power of households and businesses.

Inflation will fall back, but that will only happen if interest rates rise. As I say, this will hurt households, and so I would not be entirely surprised if the UK did endure a relatively mild recession over the coming year.

However, a recession only becomes really painful when unemployment rises significantly. We do not believe GDP will fall by anywhere near the amount it did during our last pandemic-induced recession. I do think the unemployment rate will rise a little but not significantly.

The caveat – and the real risk – is if interest rates need to go higher than we currently expect. That would cause higher unemployment.

What might happen to stock markets?

Economies are going to be weaker rather than stronger. Given this is the backdrop that will underpin the financial markets, it is hard to come to a positive view for stocks over the next six months or so.

We suspect that UK equities will have a tough time – although we do believe that they will fare better than equities in other advanced economies such as the US.

Weatherbys’ view: William Morris CFA, Head of Investments

It is certainly all too plausible that stock markets face a challenging period. But, while economies set the stage for investments, stock markets can dance an altogether unpredictable jig.

Over the coming months, much could still happen that makes even the most sensible and well-considered forecast look silly. And with so much gloom about, it is becoming easier to be surprised in a good way!

But more than anything else, we must refocus on the original case for long-term investing – which is about the capability of people to enhance productivity. We are all incentivised to find ways of doing things better and better every day.

New knowledge sticks around – it is the piece of paper with a fantastic idea on it that does not get thrown in the bin. Ever since the Enlightenment, we have had better and better explanations for the ways things work, and so we get more and more from less and less.

But these advances happen quietly, in the background. Meanwhile, financial news is noisy and usually irrelevant to your long-term goals.

The short term is very hard to predict, but in the longer term, as long as we keep collectively learning from our mistakes, I believe that you’d be a fool to call time on humanity’s long march of progress – and therefore the benefits of investing in equities.

What does it mean for Weatherbys Private Bank clients?

At Weatherbys we build portfolios that are designed to achieve the long-term objectives of our clients. We keep investments straightforward, agnostic, and good value for money.

We engineer our portfolios to be cognisant of changing economic and market conditions. For example, we factor in higher interest rates when solving for the proportions to invest in various types of assets.

But the value of the advice we provide goes well beyond that. Making sure that you have a robust financial strategy for life ahead is central to our approach. Every plan we devise is cross-checked for a second opinion, and stress-tested to make sure it can withstand these kinds of episodes of market volatility.

Remember, too, that we remain on hand to offer counsel when new challenges – and indeed new opportunities – arise.

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.