Will we see 5% plus?

BoE left with a tricky balancing act

The Bank of England (BoE) is now painting a comparatively sanguine picture for short-term economic growth prospects in the UK. Stronger than expected global growth, lower energy prices and new fiscal measures at the Spring Budget have led the central bank to move from predicting a protracted recession just three months ago to now expecting the UK economy effectively to flatline this year. It is also notable that the IMF has recently upgraded its UK 2023 growth forecast from negative into positive territory. 

These upgrades are no doubt encouraging and based on robust assumptions, but it is important to note that these growth forecasts remain subdued by historical standards. And, of course, downside risks to the outlook remain, both from geopolitical developments and other factors affecting financial markets. The BoE is currently of the view that recent global banking sector developments will only have a small impact on GDP, yet signs of tightening credit conditions in the United States will need to be monitored carefully over the coming months given the potential impact on the global economy.

While the growth outlook has improved for the UK economy, the same cannot be said for the inflation outlook. The BoE is clear: inflation is now expected to be higher for longer. CPI y-o-y inflation is expected to end the year at just over 5%, rather than just over 4%, and from this point onwards prices are expected to be sticky and not reach the 2% target by the end of 2024 (see Figure 1).

We have now, of course, had April’s y-o-y CPI figure which showed a drop from 10.1% to 8.7%. The drop in headline rate is accounted for by base effects in the electricity and gas component of inflation (see here Opens in a new window for further details) and, rather worryingly, the print was substantially higher than market expectations of 8.2%. It is especially concerning that the core rate of inflation (which excludes energy and food,) saw a significant increase from 6.2% to 6.8% and reinforces our view that prices in the services sector, which are highly influenced by wage costs, are likely to be stubborn. 

Inflation has now run hotter than expected for three consecutive months and this obviously has implications for the pathway that interest rates will follow. As of the time of writing (26 May), markets are now expecting a further 100bp of interest rate increases this year, which would take rates up to 5.5%. There will be inevitable pressure on the BoE to continue its rate hiking cycle, but it will be a difficult balancing act for rate setters given that much of the impact of previous rate rises is still due to transmit into the economy – especially as well over 80% of UK mortgages are fixed-rate. The BoE is currently conducting further work on the monetary policy transmission mechanism and is expected to publish its findings over the next year. 

A 25bp increase in June is now a near certainty, although there is considerable uncertainty about where exactly rates will peak in this cycle. 

Daniel Mahoney, UK Economist

25, 25 and another 25

No surprises again came from the major central banks this month, with the Federal Reserve, European Central Bank and the Bank of England all raising their benchmark rates by 0.25% - in line with expectations. The Fed meeting was more significant as, at least in the market’s eyes, the hiking cycle now appears to be over, with the peak being between 5.00%-5.25%.

Of course the Fed did not close the door completely on further action, but the supporting statement was amended from the March format. Back in March the statement noted that: “some additional policy tightening may be appropriate”, whereas now it says: “In determining the extent to which additional policy firming may be appropriate to return inflation to 2 percent over time the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments”. Nice and catchy!

The shift to a more balanced, data-dependant approach does support the idea the Fed will keep rates unchanged at the next meeting. Concerns still linger around US regional banks after First Republic Bank became the latest casualty, and a combination of a rapid increase in interest rates alongside reduced banking appetite is expected to lead to a significant deterioration in credit conditions – increasing the probability of a recession. Indeed the market was eagerly awaiting the latest Senior Loan Officers survey released on 8 May to confirm such tightening in credit conditions, and it did rather emphatically. The survey reported that banks have increased the spread applied to interest rates on riskier loans and reduced the size of credit lines across the first quarter. Roughly a net 46% of banks tightened lending standards on small, medium, and large firms, and 62.3% increased spreads. The report also showed deterioration in demand for credit, with the lowest readings since the Global Financial Crisis.

The question is now when will the Fed cut and how aggressive will it be? The market at one stage was fully discounting 75-100bps worth of cuts by January 2024, with a further 100bps+ throughout 2024 leaving the Fed Funds level at around 2.75% by the beginning of 2025. However this expectation is receiving pushback from officials at the Fed, such as from the likes of New York Fed President John Williams who does not see a reason to cut rates in 2023. This was followed by an array of hawkish remarks from the likes of Michelle Bowman and Neel Kashkari. However it is optimism around a deal to increase the US debt ceiling which has caused a bit of a rethink, with the market now looking at around 25-50bps worth of cuts this year as the short term economic outlook looks slightly rosier. A swift deal allows markets to price out a worst-case scenario of further deterioration in financial conditions and sentiment, as well as the potential for a US default. 

The ECB and Bank of England meetings were rather uneventful in the grand scheme of things. For the former however, whilst a 25bp hike was the baseline scenario there was some talk of a larger increase. Indeed core inflation remains sticky and data has remained resilient. The announcement to no longer reinvest any proceeds of maturing bonds purchased under the APP programme (which is simply increasing the pace of “natural” quantitative tightening for EUR 25bn a month from EUR 15bn) seems to be the sweetener given to the hawks in order to agree on a smaller hike. Despite Christine Lagarde trying to give a balanced outlook, she noted that this decision was “not a pause”. Therefore more hikes are likely, with markets pointing to two more hikes taking the peak in the deposit rate as high as 3.75%.

This side of the Channel, the MPC kept open the possibility of further hikes by not committing to any forward guidance, sensibly, and instead focus on incoming data. The lack of guidance suggests for now that the MPC was comfortable with current market pricing (which still points to a peak between 4.75%-5.00% by the autumn). There was some excitement around the revision to the GDP forecast which saw the level of GDP boosted by 2.25% in 2025, the largest upward revision in history. Worth noting this forecast is based on rates potentially reaching 5% too. Inflation forecasts were also raised, but the long-term forecast still points to inflation below the 2% target.

Feelin’ Hot Hot Hot

With the Bank of England leaving things rather open after the May meeting, focus was very much on the key April inflation number. Expectations were for a significant drop in headline inflation on the back of falling energy inflation – entirely down to the base effect with prices now being compared to a higher base in April last year. The actual figures were not pretty. Headline inflation did drop, but by a smaller amount than expected, however the more concerning point was the acceleration in the annual rate of core inflation. Subsequently markets have again readjusted their expectations for a higher base rate, not only is 5% now fully discounted by the summer, but 5.25% is now priced in for the autumn with an outside chance of the peak being 5.50%. The goalposts have moved, and we will see if this reaction proves knee-jerk. All in all, the MPC cannot sit on its hands in June, an increase to 4.75% now seems certain.

Energy update

It has been a while since we looked at energy prices on the Rate Wrap. Developments in wholesale oil and natural gas prices remain positive, although a big part of the subdued price is level is down to an expected slowdown in demand triggered by a suspected imminent US recession as well as concerns over the strength of the Chinese recovery. Brent crude oil has fallen from $85 a barrel to $74, rebounding off a low of $70 back in March. This is despite a production cut from OPEC members in April, which suggests the concern over demand is carrying more weight. OPEC will likely look at the $70 mark as a floor in the short term and will be one to watch in the coming months.

Wholesale natural gas prices remain subdued, with the price of the nearest to deliver future in Europe and the UK sitting at EUR 30 per megawatt hour and 65 pence per therm respectively. Weak demand alongside record levels of Liquefied Natural Gas (LNG) imports explain this. Indeed Europe imported 11m metric tonnes of LNG in April, whilst in recent weeks record amounts of LNG has remained idle on ships (close to May 2020 levels) which is another example of weak demand.

There is still angst around the market becoming tighter in the winter as demand naturally picks up for the heating season, coupled with the pending return of demand from Asia. Looking at the various monthly futures, we see prices picking up in November through to January. As shown in the chart below it is nothing dramatic, especially compared to prices last summer, but there is a kink. 

Nevertheless energy inflation will turn negative, when taking into account base effects. It was announced this month that the energy price cap for the average user will drop in July from £3,268 to £2,074 – a 17% drop from the current £2,500 energy price guarantee.

If this has whetted your appetite for more markets analysis, in a special edition of our Handelsbanken Insights podcast (link below) we cover off developments in the energy and foreign exchange market, all within the context of the current high interest rate and inflationary environment.

Cameron Willard, Capital Markets

All data, unless otherwise stated, is sourced from Bloomberg