James Lynch, Fixed Income Manager at Aegon AM, comments on expectations for interest rates in the UK.
“There are caveats in using monetary policy to manipulate inflation. The first of these is that it is only supposed to work with a lag – the Bank of England uses 18 months as a rough gauge. So, if inflation is rising now, using interest rates is not going to do anything to inflation for 18 months, and who knows what the economy will look like then.
“Second of these caveats is the type of inflation – the BoE does not think interest rates will do anything to offset the rises in energy prices, which we have in abundance currently.
“However, the BoE has just raised interest rates at three consecutive meetings to 0.75%, because the starting point is also important. Policy was at the most easy/loose/lowest rates in history last December. That was not appropriate for the economic growth, labour market and inflation we are experiencing in 2022, so it is easy to start to move rates higher – at least to somewhere around a neutral level with that backdrop.
“But now we are at a tricky juncture, should they keep going? The market says yes, it forecasts interest rates rising to a lofty 2.5% by August 2023. To raise interest rates at that speed requires an abundance of confidence that the BoE knows what the economic outlook is going to be over the medium term as the effects of an interest rate move happen with a lag. But we know that not to be the case, the BoE are not confident, it sees risks everywhere, namely lower consumer demand due to the cost-of-living crisis.
“So why do we have this pace of hikes? The market is focusing on near term inflation, which equals hikes and is ignoring the lag and/or negative effects on incomes. In addition, over in the US the communication from their Central Bank ‘The Fed’ has turned super hawkish, talking up the possibility of raising rates in 0.50% increments starting in May. This has led to all bond/interest rate markets moving in sympathy.”