Interactive Investor

Massive week ahead for interest rates in the UK and America

3rd May 2022 15:18

Graeme Evans from interactive investor

With both economies set to tighten monetary policy over the coming months, there are growing fears of hard landings ahead in the fight against inflation.

Efforts to bring inflation under control will this week see UK interest rates hit 1% for the first time in 13 years and the US equivalent increase by the most in over two decades.

In a significant few days for monetary policy, tightening by the US Federal Reserve on Wednesday is expected to be the first part of a series of 0.5% back-to-back rises in US rates.

With subsequent increases forecast to leave rates at near to 2.5% by the end of 2022, the 10-year US bond yield yesterday topped 3% for the first time since December 2018.

This backdrop has accelerated a flight from risk as investors jettison technology and growth stocks in anticipation that higher interest rates will depress the value of future cash flows.

Mega-cap tech stocks in the US were hit particularly hard in April, with Deutsche Bank reporting that the FANG+ index fell 18.9% in its worst monthly performance since the benchmark was launched. It is down 27.9% across the year so far.

Expectations for a half-point rise in US rates increased further on Friday, when the Federal Reserves preferred gauge of price pressures showed an increase by 6.6% in the year in March, the fastest pace of growth since 1982.

Even though favourable base effects will soon weigh on inflationary pressures, Fed policymakers accept it may take a couple of years to get inflation back on track.

They will be concerned by the extremely tight labour market conditions, which risk inducing a wage-price spiral and more persistent inflation. There are currently almost two vacancies for every unemployed individual in the US.

Demand conditions also remain strong, but economists expect a weakening in momentum by the end of the year as inflationary pressures eat into real spending power.

The increased chances of a hard landing for the US economy ensure that comments from Federal Reserve chairman Jerome Powell after tomorrows meeting are likely to be just as significant as any half-point rise.

However, the deteriorating economic outlook means London-based Investec Securities isnt expecting US rates to rise as fast as financial markets are currently expecting.

Economist Ellie Henderson says a significant slowdown in the housing market could also persuade policymakers to hit the brakes. She adds: How Powell plans to navigate policy tightening in light of the multitude of headwinds to growth will be of key interest.”

Bank of England governor Andrew Bailey will also be in the spotlight on Thursday when policymakers present their latest economic forecasts alongside the rates decision.

When the Bank raised interest rates at its March meeting to 0.75%, it struck a relaxed tone in its guidance by saying only that a further modest tightening of policy might be appropriate.

However, that was before the inflation figure for March of 7% came in five percentage points ahead of the Banks 2% target and higher than its 5.9% projection in February.

The fall in the pound from $1.30 in mid-April to $1.24 before the weekend means that currency effects have the potential to become another unhelpful source of inflation. Investec sees inflation peaking at 9.7% by October, when the bank is factoring in a 48% rise in the energy price cap on top of the 54% increase seen this month.

Chief economist Philip Shaw points out that raising rates will do very little to moderate inflation over the next six months, and that the aim of tightening policy now is to prevent inflation from remaining above 2% over the medium term.

He expects another rates hike to 1.25% in August, but his prediction of a subsequent pause until early 2023 contrasts with markets pricing in rates of 2.25% by the year end. Capital Economics recently raised its forecasts by predicting rates of 3% next year.

Shaw adds: Should the downside risks to the economy be realised, there is a chance that the monetary policy committee will have to reverse at least some of the tightening.”

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