Interest rates

Interest rates will likely rise much less than most people predict

Inflation was already a serious problem thanks to bottlenecks in the global supply chain caused by the COVID-19 pandemic. But following Russia’s brutal invasion of Ukraine and its effect on oil and gas prices, inflationary pressures now look much worse.

The big question is how central banks will react. High inflation requires higher interest rates, but it may worsen global economic damage likely to be caused by Western sanctions against Russia. The Bank of England has been slightly ahead of the monetary policy tightening curve, having raised the key interest rate twice in the past two months reach 0.5% and also end his quantitative easing (QE) program to increase the money supply in December.

The Fed’s QE program has only just ended, and it has yet to raise interest rates. With the Fed and Bank of England set to make their final monthly decisions, what can we expect?

The story so far

UK consumer price inflation currently stands at 5.5%, more than double the Bank of England’s 2% inflation target, and it’s expected peak at 7% in April or even higher if there is a sustained increase in energy prices. US inflation, meanwhile, is already pushed 8%.

Financial markets currently waiting the Bank of England’s Monetary Policy Committee (MPC) to raise the key interest rate to 0.75% on March 17 On the way to a peak of 2% per year by then, where it is expected to hold until the end of 2023. The US equivalent rate is at 0.25%. It is likely to be increased at the last meeting for the first time in this cycle by 0.25 or 0.5 points, possibly before around 2% by the end of the year.

UK interest rate market expectations (%)


Author provided

Yet the reality is that financial markets have constantly overrated the path of interest rates. In the words of the bestselling author Dan Brown in The Da Vinci Code, “Today is today. But there are many tomorrows.”

UK Rate Forecast

I have built a monetary policy tool which I use to predict where UK interest rates are likely to go next. This is based on four different factors: the Bank of England inflation forecast, compared to the official target of 2%; the bank’s most recent interest rate decision; the level of excess demand in the economy, based on Office for Budget Responsibility (OBR) data; and an aggregate risk index, on the basis that heightened perceptions of risk are bad for economic growth because it makes consumers and businesses less likely to spend and invest. This in turn may delay interest rate increases.

I construct the aggregate risk index by combining various information: 50% comes from a measurement of economic policy uncertainty which records the number of UK newspaper articles containing various relevant terms such as ‘uncertainty’, ‘economic’ and ‘deficit’; 20% is one financial stress score based on the volatility of the pound sterling and the UK stock and bond markets; 20% is based on the market volatility of Infectious diseases; and 10% is a measure of global geopolitical risk.

The graph below shows the overall risk index over a long period. It increased following major events such as the 9/11 terrorist attacks, the global financial crisis of 2007-2009 and the UK’s decision to leave the EU in 2016. It also increased during the first stages of the pandemic in 2020, and is after the war in Ukraine, albeit slowly, since, apart from the geopolitical risk element, the other parts of the aggregate index have not risen sharply.

Aggregate risk index, 1998-2022

Graph showing overall risk over time

Author provided

My policy tool assumes that inflation remains as high as 3.1% in the first quarter of 2024 – significantly higher than the 2.15% forecast made by the Bank of England before the invasion of Ukraine. It also assumes that inflation returns to the 2% target by the end of 2024.

The tool also assumes a negative effect on UK economic growth: 1 percentage point lower than its potential growth in the second and third quarters. This is due to rising energy prices, the government’s decision to phase out Russian oil imports by the end of 2022 and high general war-related uncertainty. (It should be noted that the UK gets about 4% of its gas and about 11% of its oil from Russia.)

Regarding the overall risk index, the assumption is that the current crisis does not degenerate into a generalized and persistent war. I assume the index rises to 0.35 in mid-2022 before returning to zero by the end of 2023.

What happens next

Based on these assumptions, I expect the latest MPC meeting to raise UK interest rates, in line with market expectations, to around 0.75%. But that will then take them to just 1.3% by the end of 2023, considerably less than what financial markets are predicting. And while I don’t project US rates the same way, it might be reasonable to expect Fed decisions to follow a similar trajectory.

As far as the UK is concerned, different policy tool assumptions obviously lead to different interest rate forecasts. For example, some might argue that my weighting of 10% for geopolitical risk in the calculation of total global risk is too low. After all, in 2001, the MPC responded to the attacks of September 11 by organizing a special meeting in which he cut the policy rate from 5% to 4.75%.

For this reason, the chart below shows both the policy tool’s interest rate forecast over the next two years in blue and an alternative scenario in red in which each element of the aggregate risk index has a weighting of 25%. Interestingly, the alternative scenario predicts that the MPC will leave interest rates unchanged at the next meeting and be even more dovish in 2022 and 2023 than in my main prediction. Indeed, a higher weight on geopolitical risk (amount) thwarts, to a large extent, interest rate hikes due to rising inflation, as this implies more damage to growth.

BoE Interest Rate Forecast 2022-23 (%)

Chart showing interest rate forecasts over time

Author provided

Other results are also possible. If, for example, the current crisis worsens much further, pressures on energy prices will push inflation well above 3% in two years. Yet the risk index would also rise accordingly, and UK growth would take a further hit. In such a situation, the Bank of England would be faced with an acute dilemma of stagflation. This would make interest rate decisions even harder to predict, as a hit to UK growth would open the door to interest rate cuts – and potentially more QE.