UK interest rate outlook

UK interest rate outlook

The war in the Middle East has rewritten the future path for UK inflation and interest rates. In mid-February inflation was on course to return to its 2.0% target rate, and financial markets expected the Bank of England to cut interest rates from 3.75% to 3.25% by the end of the year.

• Higher energy prices pushed inflation from 3.0% in February to 3.3% in March. On the Bank’s most optimistic forecast scenario UK inflation will now peak at around 3.6% at the end of this year. Its most severe scenario, of persistently elevated energy prices creating a wage price spiral, sees inflation peaking at 6.2% early next year. 

• No wonder financial markets assume that, far from cutting rates, the Bank will raise them by 25bp in July and again in September, taking them from 3.75% to 4.25% at the end of the year, 100bp higher than expected in early February.   

• Economic forecasts and market pricing warrant attention but are often wrong. The Bank of England’s latest Monetary Policy Report (MPR), published last week, provides a skilful analysis of the outlook and the risks, but the Bank can no more predict the impact of this energy shock than the one following the invasion of Ukraine in 2022.

• The Bank underestimated the scale and the persistence of that episode, and it seems determined to avoid repeating the mistake. The Bank is clear that it can do nothing to mitigate the initial impact of higher energy prices. Its focus is on second-round effects, with the risk that higher energy prices fuel wage pressures and encourage firms to raise prices.

• Whether such second-round effects materialise will depend on underlying strength of activity across the economy.

• In early 2022 the UK economy was running hot as the economy bounced back from the pandemic, with inflation and wages on the rise and unemployment close to an all-time low. An abrupt rise in energy costs, coming at a time of strong growth, triggered sizeable and persistent second-round effects that took inflation to a peak of 11.1%.

• The backdrop today is quite different. With the exception of a strong first quarter, which looks like a one-off, growth in the last year has been subdued. Inflation and wage pressures have been easing while unemployment has risen and is above the levels that have prevailed for most of the last ten years.

• Higher energy costs have already driven up mortgage costs and rates on lending to corporates. Higher borrowing costs, coupled with a squeeze on spending power caused by higher energy prices, will tend to depress growth.

• A weak jobs market gives workers less scope than in 2022 to seek wage rises. According to the latest Deloitte CFO Survey, UK businesses have doubled down on cost reduction in the wake of the conflict in the Middle East while corporate hiring intentions have fallen to levels last seen in 2020 in the early days of the pandemic. Consumers have become more concerned about inflation and worry that it may be here to stay. But their ability to compensate by pushing through offsetting wage rises appears to be limited.

• The Bank seems more concerned that firms will respond to higher inflation by raising their prices. Profit margins are narrower than in 2022 giving firms less scope to absorb higher prices. The surge in inflation after the pandemic means corporates are more sensitive to inflation and are changing prices more frequently than in the past. The Bank’s latest Decision Maker Panel survey shows that 64% of firms expect to increase prices over the next year in response to higher energy costs.

• Where does this leave prospects for UK interest rates?

• Even the Bank’s relatively benign forecast scenarios suggest the need for rates to rise by perhaps 50bp this year. Financial markets have priced in exactly this outcome. However, the Bank’s governor, Andrew Bailey, challenged such notions in an interview after the release of the MPR last week when he said, “I would caution against reaching any strong conclusions about us raising interest rates”.

• I agree. My guess is that this energy shock will dampen growth and, once the initial impact of higher energy prices abates, inflation will fall back. Rate hikes are not yet a done deal.

OUR REVIEW OF LAST WEEK’S NEWS
The UK FTSE 100 equity index ended the week down 0.1% at 10,364.

Middle East conflict

• The US said that it had intercepted Iranian missiles launched at commercial vessels and US warships in the Strait of Hormuz, and that it had also struck several Iranian boats. The UAE said it had also intercepted several Iranian missiles
• Oil prices ended the week at $109 per barrel, after reaching highs of over $126 earlier in the week over fears of a prolonged conflict between the US, Israel and Iran
• The United Arab Emirates announced it would leave the OPEC group of oil-producing countries. The country has considerable spare production capacity, which if utilised could put downward pressure on prices once disruption to shipping is resolved
• Iranian annual inflation increased to 50% in April, up from pre-conflict levels of around 40%, as disruption to shipping through the Strait of Hormuz continues
• German chancellor Friedrich Merz said the US was “being humiliated by the Iranian leadership”. On Friday the Pentagon announced the US would withdraw 5,000 troops from Germany amid the public spat between Mr Merz and Mr Trump
• The US Department of Defence said that the US’s military operation in Iran has cost approximately $25bn so far, most of which was spent on munitions
• The UK government announced new contingency plans to allow airlines to cancel flights weeks in advance without losing landing slots if they face fuel shortages

Economics

• Central banks of the US, UK, Euro area and Japan held interest rates last week amid expectations of rising inflation due to the conflict in the Middle East
• Commenting after the S&P 500 hit record highs on Friday, Warren Buffett, former boss of Berkshire Hathaway, said “we’ve never had more people in a more gambling mood than now” and predicted that “prices for an awful lot of things will [in time] look very silly”.
• Kevin Warsh’s nomination to become the next US Federal Reserve chair was approved by the US Senate Banking Committee. Current Fed chair Jay Powell said he would remain on the rate-setting committee, despite repeated criticism from the US government for not lowering interest rates
• President Donald Trump announced that he would lift tariffs on Scotch whisky “in honour” of King Charles during a state visit to the US by the monarch
• The US economy grew at an annualised rate of 2% in the first quarter of this year, up from 0.5% in the previous quarter. More than half of the growth was attributed to AI investment
• The US’s personal consumption expenditures price index, the Fed’s preferred measure of inflation, rose to 3.5% in the year to March, up from 2.8% in February
• US consumer confidence improved marginally in April, according to the Conference Board, however confidence remains close to pandemic-era lows
• Euro area inflation rose to 3% in the year to April, up from 2.6% in March. Meanwhile, GDP growth slowed to 0.1% in the first quarter
• UK house prices unexpectedly increased in April, by 0.4% compared with the previous month, according to Nationwide
• The Office for National Statistics forecast the UK’s population will increase by 1.7m to 71m over the next decade, a downgrade from its previous estimate of 72m, due to lower migration and fertility rates
• Emerging market equities have recovered their losses since the start of the conflict in the Middle East to reach an all-time high, driven by the strong performance of a handful of Asian chipmakers

Business

• The S&P 500 US equity index saw its strongest monthly performance since 2020, rising by 10% in April due to strong gains from technology companies
• US tech company Apple surpassed market expectations for revenue growth in the first quarter this year, which it attributed to strong sales of the latest iPhone 17
• The US Federal Communications Commission ordered a review of TV stations owned by Disney for violations including unlawful discrimination. The move follows criticism by Mr Trump over comments made by comedian Jimmy Kimmel on Disney’s ABC news channel
• UK pharmaceutical company AstraZeneca said it would resume £300m of planned investment in its Cambridge research facility following the UK government’s announcement that it would increase spending on medicines as part of a trade deal with the US
• The UK Renter’s Rights Act came into force last week, which included abolishing fixed-contract tenancies agreements and Section 21 ‘no-fault’ evictions
• UK consumer bank NatWest announced a 12% rise in pre-tax profits for the first quarter, driven by higher interest rates
• UK National Energy System Operator chief executive Fintan Slye made the case for building data centres in Scotland instead of south-east England to avoid pre-existing grid constraints and help reduce energy costs for consumers
• German energy company Eon is in advanced talks to take over UK rival Ovo in a deal worth up to £600m, the FT reports
• German carmaker Volkswagen announced plans to reduce global production capacity amid higher US tariffs and pressure from Chinese rivals
• The UAE’s Abu Dhabi National Oil Company announced plans to invest billions to build a natural gas business in the US as part of plans to diversify across the entire gas supply chain

Global and political developments

• UK prime minister Keir Starmer won a vote in the House of Commons that called for an inquiry regarding whether he misled parliament about Peter Mandelson’s appointment as UK ambassador to the US
• Reform UK and the Green Party are expecting to make significant gains in elections across England, Scotland and Wales this week. The Scottish National Party and Plaid Cymru are expected to be the largest parties in the Scottish parliament and Welsh national assembly elections, respectively, according to the latest polls

And finally… two farmers in Vermont were left stunned after their sheep gave birth to sextuplets. The farmers were only expecting twins, with the birth of six healthy lambs estimated by some sources as being a one in a million event – more than they baaa-gained for