Rates staying higher for longer, though, is not the same as saying that policy rates should and will not fall. It is possible to have both rates falling from present levels, and then staying at a much higher level than was the case before the pandemic. It is also necessary to differentiate, naturally, between regions and countries, although with financial markets heavily focused on the US, the outlook there can sometimes impact how the markets see other central banks like the Bank of England and European Central Bank acting, too.
This week saw a sharp shift in market thinking about the outlook for US interest rates. In March, the annual rate of consumer price inflation rose from 3.2% in February to 3.5%. Core inflation, which excludes food and energy, remained at an annual rate of 3.8%. This was followed by news that the annual rate of producer price inflation had risen from 1.6% in February to 2.1% in March. It also followed strong jobs growth in March.
With the US Federal Reserve having a dual mandate for low inflation and steady jobs growth, such data has eased pressure for any immediate easing. That said, there has been much focus recently too on surveys covering small firms from the National Federation of Independent Business (NFIB) that suggest credit conditions are tight, and that confidence is ebbing. It will be interesting to see whether this is reflected in forthcoming data, for as things stand currently, the US economy appears resilient.
Of course, unlike here in the UK, fiscal policy has been very stimulative. Indeed, the economic picture and impact on inflation in the US may prove to be very different to the UK and euro area. If so, it may be that the Fed chooses to leave rates on hold this year.
There has been a dramatic change in market thinking about policy rates since the start of the year. Then, markets were discounting around six rate cuts in both the US and UK during 2024. Now, in the wake of the latest US economic data, the market expects two or less rate cuts this year in both countries.
The US inflation data that triggered the shift in market sentiment was followed a day later by a loosely argued comment column written by a hawkish member of the UK’s Monetary Policy Committee arguing against an early rate cut. This combination also led to a shift in expectations about UK rates, away from a possible cut this quarter, to the market now expecting that the first reduction will be in September.
During this year – when the market has moved from expecting six and now two rate cuts in 2024 – we have kept our forecast unchanged, with the UK economy largely behaving as we had expected. We have said that we thought the first rate cut in the UK should be by the end of June, with rates subsequently down to 4.5% by year end. We did say that this was not guaranteed, although we did expect rates to finish the year around 4.5% to 4.75%. That remains our thinking.
Whether it is the Bank of England, or the US Federal Reserve, or the European Central Bank to be able to start easing, they need to see evidence that core inflation is improving and they also need to be confident about the future direction of inflation. This is not yet the case.
The challenge, though, for these central banks is that they have now made clear that their rate decision is fully dependent, it seems, on current economic data. That is, monetary policy has become coincident, as opposed to being forward looking, as it should be. This adds to the risk that markets can overreact to any economic release if – as was the case in the US this week – it shows inflationary pressures are higher than expected.
While this shouldn’t tie the central bank’s hands, it probably will. If the latest data is poor and the market is no longer expecting an immediate cut, it makes it more difficult for any of these central banks to ease and to be seen as credible if it does so. Guiding and winning the market’s confidence is always important in policy making. It doesn’t rule out shock or surprise decisions, but it reinforces the importance of clear and effective communication.
In the UK, after a technical recession at the end of last year, the economy has shown signs of improvement so far this year. However, activity is still very weak and growth sluggish, with the UK economy growing by 0.1% in February.
Decelerating inflation should allow real incomes to rise and the economy to recover as the year progresses. Yet financial conditions are tight and the full impact of previous monetary policy tightening has yet to feed through. Inflation looks set to decelerate below 2% in coming months. This should add to the pressure for interest rates to fall.
The BOE hiked policy rates from 4.5% to 5% last June and from 5% to 5.25% in August. At the last policy meeting, in March, the MPC voted 8-1 to leave rates at 5.25%, with Swati Dhingra voting for a cut to 5%. With three members of the MPC appearing hawkish (Greene, Mann and Haskel) this helps explain why the market is not expecting an early rate cut. But as inflation decelerates, the pressure may build, because even though the economy is recovering, growth is still tepid.
Even when UK rates do start to fall it seems sensible to expect rates to stabilise at a higher level than pre-pandemic. Our view has been that this will be around 4% to 4.5% in line with the possible growth of nominal GDP. Events this last week add to the case for rates staying higher for longer, and may point to a divergence between the ECB, BOE and Fed about the timing of the next move.
Please note, the value of your investments can go down as well as up.
