UK interest rates could potentially rise up to 4.75 per cent by the end of 2023, argues Costas Milas. This is because high public expectations of inflation have the potential of putting additional pressure on current inflation through demand for higher wages. If, instead, financial stress worries take over, UK interest rates might end up below 4 per cent by the end of 2023.

The Bank of England’s (BoE) policy rate currently stands at 4.25 per cent. The Bank’s policy rate sets the tone for movements in other UK interest rates such as mortgage and lending rates. Therefore, movements in the Bank’s policy rate matter for households and businesses. With this in mind, it is natural to ask the following questions: Has the Bank’s policy rate peaked at 4.25 per cent? If not, will it rise further? Is, instead, an interest rate cut “on the cards”?

The latest Consumer Price Index (CPI) inflation reading of 10.1 per cent for March 2023 could offer some hints on the next interest rate move. CPI inflation stood at 10.2 per cent for 2023Q1. This is higher than the Bank’s inflation forecast of 9.73 per cent. Inflation is therefore proving more stubborn than what the Bank expects. So it makes sense to expect that the Bank’s Monetary Policy Committee (MPC) will raise interest rates further.

Interest rate predictions are far from straightforward, especially in periods of elevated financial stress.

Nevertheless, interest rate predictions are far from straightforward, especially in periods of elevated financial stress like the current one. BoE Governor Andrew Bailey noted, in a recent speech, that “financial stability continues to mean that monetary policy takes into account financial conditions”. This is not surprising. Professor Chris Martin (from the University of Bath) and I published in 2013 an academic paper at The Journal of Financial Stability which showed that the BoE takes into account financial conditions in addition to inflation and output developments when setting UK interest rates.

Determining the direction of travel

To understand whether UK interest rates will rise above 4.25 per cent, I estimate an “interest rate reaction function” which takes into account three main variables. The first one is the Bank’s two-year inflation forecast, namely the most likely outcome based on market expectations of interest rates relative to the 2 per cent inflation target. The second one is the Office for Budget Responsibility (OBR) output gap measure of excess demand in the economy. The third one is an indicator of financial stress conditions in the UK compiled by the European Central Bank. The indicator includes market-based financial stress measures that are split equally into five categories: the financial intermediaries sector, money markets, equity markets, bond markets and foreign exchange markets. The BoE monitors financial stress indicators. This is because rising financial stress can suppress UK growth for approximately 20 months down the road as noted in a paper of mine (jointly with colleagues at Liverpool University) published in 2022 by The European Journal of Finance. Financial stress also impacts negatively on growth in other countries, including the US.

The latest financial stress reading for the UK indicates decelerating financial stress compared to its early/mid-March reading (when the Silicon Valley Bank and Credit Suisse events dominated the news). Notice also that the current reading of financial stress is also lower than what was observed during the (disastrous) Truss-Kwarteng (mini-)budget of September 2022. The latest moves in financial stress are reassuring in the sense that a banking crisis is not, as things stand, of immediate concern.

The “too good to be true” scenario

Assuming that (a) CPI inflation drops below 1 per cent by the end of 2025 in line with BoE forecasts; (b) output gap drops from 0.4 per cent in late 2022 to -1.6 per cent by the end of the current year in line with OBR forecasts, and (c) that financial stress stays at its current (in April) level for the rest of 2023, the empirical interest rate reaction function does not point to further interest rate increases by the end of 2023. This is ‘too good to be true’ because the BoE has underestimated, as recently as February 2023, inflation for the current quarter by a massive 0.5 percentage points. So, the worry is the following: If the BoE cannot forecast “well enough” short-term inflation, how on earth can it forecast inflation two years down the road? This is not a trivial question because the BoE relies on its inflation forecasts two years into the future to decide on interest rates today.

If the BoE cannot forecast “well enough” short-term inflation, how on earth can it forecast inflation two years down the road?

The most likely scenario

Economic life is, therefore, not that simple because the BoE has consistently underpredicted future inflation. Contrast this with public expectations of CPI inflation remaining as high as 3 per cent in 2025. The latter is highly problematic for two reasons. First, the public expects higher  inflation than the BoE (that is, 3 per cent versus less than 1 per cent) which creates, of course, additional inflation pressures through, for instance, demands for higher wages. Second, the high public expectations of inflation compared to the Bank’s own forecasts imply that the public does not trust the Bank’s forecasts.

This questions the BoE’s ability to bring inflation down to the 2 per cent target. Consequently, If we are willing to assume that CPI inflation remains stubbornly high at 3 per cent two years down the road and/or that the output gap does not fall by as much as the OBR currently predicts, the interest rate reaction function points to UK interest rates rising to 4.5 per cent or slightly more to 4.75 per cent by the end of the current year.

The above interest rate predictions depend on financial stress not escalating further. There is growing expectation that the Chancellor of the Exchequer, under advice from the BoE, will increase the level for guaranteed UK deposits, from £85,000 currently. This suggests to me that UK regulators are somewhat worried that we have not fully escaped the risk of a financial/banking crisis (initiated in March via the Silicon Valley Bank and Credit Suisse events). Consequently, if a considerable rise in financial stress occurs, interest rate cuts could be implemented before the end of the current year. Interesting economic times lie ahead of us.

Note: Financial markets participants are currently talking about an increase in UK interest rates to 5 per cent before the end of the year. I cannot see this, at the moment, unless of course the BoE revises massively upwards its own inflation forecasts. Such a revision would severely undermine the Bank’s forecasting ability and credibility.

All articles posted on this blog give the views of the author(s), and not the position of LSE British Politics and Policy, nor of the London School of Economics and Political Science.

Image credit: Photo by James Stringer, Creative Commons — Attribution-NonCommercial 2.0 Generic — CC BY-NC 2.0