IS THE BANK OF ENGLAND TIGHTENING CYCLE ALMOST FINISHED?

09.11.2022 Last week’s Bank of England inflation report suggested a peak in inflation by year end and then a rapid descent next year. As a result it thinks that the tightening cycle maybe nearing its end. Below we look at how realistic this is.

Last week’s Bank of England inflation report presented two scenarios. The first scenario was based on the interest rate expectations priced into financial markets, which at the time the report was written, implied a peak rate of 5.25 percent. This generated inflation well below the 2 percent target after 2 years. By contrast, in the second scenario interest rates of 3 percent (the current interest rate) generated an inflation rate of 2.2 percent after 2 years. Generally, if inflation is above the 2 percent target after two years this is a signal that the Bank expects to raise rates further, while if it is below 2 percent this suggests further interest rate cuts are necessary. So, the implication of the above is that with inflation close to 2 percent after two years and below 2 percent after three years, on unchanged rates, the Bank of England is trying signal that the end of the tightening cycle is near.

For interest rates going forward a key event will be the fiscal statement on November 17^th. Jeremy Hunt is looking for around GBP 50 bn in tax rises and spending cuts. If these are front loaded into 2023 and 2024 then they will represent a significant negative shock to the UK economy. This will mean that fewer interest rate rises will be needed. If much of the pain is deferred until after the 2024 election then it is likely that further interest rate rises will be needed.

The other key issue facing the economy is the impact of the exit from a decade of ultra-low interest rates.  It is widely accepted that it will prompt a significant correction in the housing market. This will have a negative impact on consumer spending via fewer housing transactions and lower personal wealth. However, it will also impact a group of companies that for last ten years have just about been able to service their debts. As interest rates rise and the supply of credit becomes more constrained these companies will be forced into restructuring. It is estimated that they represent between ten and twenty percent of all UK enterprises. So, the shock to the economy and the associated rise in unemployment next year could be significant.

On the assumption that a reasonable amount of the government’s fiscal tightening happens before the 2024 election we think that the Bank of England will continue to cautiously raise interest rates until inflation has started to fall. Last week’s inflation report suggests the Bank is increasingly concerned about the potential long-term damage to the economy from over tightening monetary policy. As a result, we look for the Bank of England to pause its cycle of interest rate rises at 3.75% in the Spring of 2023.

For information only. Investors should seek professional advice for their own circumstances before making an investment.

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This post was written by Robin