Interactive Investor

Is this predicted peak in UK interest rates crazy or not?

1st February 2023 13:14

Graeme Evans from interactive investor

Central banks in the US, UK and Europe are about to announce by how much interest rates will rise this month. Our City writer looks at how high borrowing costs might go and when they might fall.

Peak interest rates will move into view in the UK, US and Europe this week, but investors will be told the work of central banks in combating inflation is not yet over.

Another 0.25% increase is tonight set to take US interest rates to a range of 4.5% and 4.75%, representing the first normal-sized rise by Federal Reserve policymakers since their aggressive hiking cycle began in March last year.

Wall Street futures are pricing another 0.25% hike in March 2023 and one-in-three chance of a further one after that, with hopes building for rates to be cut by the end of the year.

These expectations have triggered gains for the S&P 500 and the Nasdaq in recent sessions, even though the message from policymakers that rates will stay high for some time is set to be reinforced by Federal Reserve chair Jerome Powell at tonight’s press conference.

US inflation has fallen for the past six months, but is still high at 6.5%, and with a tight labour market the Fed will be in no mood to let price pressures start creeping back up.

This means no change to December’s Federal Reserve guidance that ongoing increases in the target range will be appropriate. UBS said: “Despite good news on inflation and being one step closer to done, it's likely too soon for the Federal Reserve to stop raising rates and likely too soon to signal a stop is imminent.”

Bigger rises of 0.5% are widely expected by the Bank of England and European Central Bank (ECB) when their policy meetings reach their conclusion tomorrow.

A second consecutive increase of this size will take the UK’s base rate to 4%, with economists expecting another move of 0.25% in March. Hopes that this might then be the end of the cycle have been boosted by a recent sharp drop in wholesale gas prices, which may mean inflation comes down faster than the monetary policy committee previously expected.

Governor Andrew Bailey believes there’s now an easier path back to the Bank’s inflation target of 2%, but he will remain concerned about the impact of recent wage growth acceleration and signs of sticky core inflation.

The bank’s updated economic forecasts are due alongside the rates decision and will look very different to the figures presented in November in the aftermath of the mini-budget.

Instead of a recession that lasts for eight quarters and includes a peak-to-trough fall in real GDP of 2.9%, the new forecasts will incorporate a shorter and shallower recession.

For now, Capital Economics thinks the Bank’s monetary policy committee will stick to previous warnings that further rate rises might be required and that it would “respond forcefully” to signs of persistent inflationary pressures.

However, the consultancy’s chief UK economist Paul Dales added: “We think the Bank’s new economic forecasts will roughly imply that the markets are not too crazy in expecting interest rates to peak around 4.25-4.50%.

“And it might only be a month or two before the MPC decides to signal that rates are close to a peak and that it will subsequently keep them on hold for a while.”

Beyond tomorrow’s expected 0.5% rise in the ECB’s deposit rate to 2.5%, economists will be looking for any guidance that policymakers may be considering a smaller increase in March.

UBS’s base case is for a further 0.5% rise to a terminal rate of 3% on 16 March, but with a risk that the ECB could follow up with another hike in May to 3.25% or even 3.5%.

However, the Swiss bank added that a broad-based improvement in the inflation environment could yet fuel discussion around a 0.25% hike in March and a lower terminal rate. These hopes were boosted today when the annual inflation rate in the euro area fell by more than expected to an eight-month low of 8.5% in January.

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