In the last year, many developed market economies have raised interest rates to combat surging levels of inflation in the global economy. After 10 consecutive interest rate increases in the US, and 12 in the UK, investors are now anticipating a peak for interest rates in the coming months.
Is the end in sight for the global monetary policy hiking cycle, or are structural factors at play that mean rates need to remain high for some time? These are important questions for policy makers in the coming months. Here’s a look at the outlook for interest rates for the UK, the US, and the Eurozone.
This article isn’t personal advice, if you’re not sure what’s right for you, ask for financial advice. All investments fall as well as rise in value, so you could get back less than you invest.
Kathleen Brooks is Founder of Minerva Analysis, a market analysis company. Hargreaves Lansdown may not share the views of the author.
The US – after an aggressive hiking cycle, comes an aggressive cutting cycle
The end could be in sight for the Federal Reserve’s (Fed) rate hiking cycle. Market-based interest rates are expecting rates to have peaked at the current level of 5-5.25%. There’s currently 92 basis points of interest rate cuts expected between July and January 2024.
There are growing signs of dents in the US economic outlook, including rising initial jobless claims. The latest data shows that the four-week moving average for claims has risen by 6,000 to 245,250, which is the highest level since November 2021.
The New York Fed’s Empire manufacturing survey, which is considered a bellwether of manufacturing health across the US, fell sharply in May, dropping 43 points to -31.8. This was led by a large decline in new orders and shipments, which herald further weakness down the line. Combined with the fallout from the US regional banking crisis, this could mean that a pause is on the cards after one of the most aggressive rate hiking cycles from the Fed in decades.
However, are financial markets too optimistic about interest rate cuts and will the peak in the Fed Funds rate be as swift as some expect?
Sticky inflation is going to make the Fed’s job harder from here onwards. Long-term inflation expectations jumped to 3.2% from 3% in April, the highest level since 2011. Even after 10 interest rate hikes, inflation expectations look like they’re not anchored to the Fed’s 2% target rate for annual price growth.
Right now, the market thinks that cracks in the economy are enough to cause the Fed to cut rates. But if inflation stays high for too long, we could see reduced expectations for interest rate cuts later this year.
The ECB – playing catch up
The European Central Bank (ECB) slowed the pace of rate hikes in May to 25 basis points, pushing up the ECB’s main deposit rate to 3.25%. However, President Lagarde emphatically pointed out that the ECB isn’t pausing, and signalled that more rate hikes could be on their way. This was the seventh straight hike from the ECB, and its smallest hike so far, after a raft of 75 and 50 bp rate hikes.
The ECB started their rate-hiking cycle after the Fed and the Bank of England (BoE), so it’s no surprise that it will also be hiking interest rates at a slower pace.
However, the ECB might be closer to their peak in rates than some think. For example, there are signs that interest-rate sensitive sectors of the economy are coming under pressure from higher borrowing costs. Industrial production for March fell by 1.4% compared to a year earlier, and wholesale prices in Germany declined at a 0.5% annual rate in April. This could be a sign that the ECB is winning the fight against inflation.
On the other hand, the Centre for European Policy Research, asked its panel of economists if they thought inflation had passed its peak, and what that implied for ECB policy. The majority of the panel thought that inflation in the currency bloc has passed its peak. But, half of the panel also thought interest rates will need to move higher to keep inflation under control.
The market’s currently expecting 27 basis points of further tightening from the ECB between June and September. That would push the ECB’s terminal rate to 3.5%. After that, the market’s expecting the ECB to be much slower at cutting rates compared with the Fed. There are only 18 basis points of interest rate cuts priced in between September and the start of February 2024.
It's unlikely that the ECB will hike interest rates to the same level as the Fed or the BoE, due to the sensitivity of sovereign debt to rising interest rates.
Euro area sovereigns issued significant amounts of debt during the pandemic. The euro-area debt to GDP ratio increased to 100% of GDP in 2020, which is higher than the 95% reached in the aftermath of the euro-area sovereign debt crisis.
While risks associated with higher interest rates seem manageable for debt-laden Eurozone sovereigns for now, the ECB found that risks could rise if there’s a growth shock in the future. This could trigger a reassessment of sovereign debt risk. So, while we can expect the ECB to hike rates again this summer, it will follow a careful path after that to make sure sovereign debt risks don’t rise to crisis levels.
The UK – one and done?
The BoE was the first of the major central banks to hike interest rates back in December 2021. It’s since hiked interest rates 12 times, with rates currently at 4.5%.
The market expects UK rates to rise by a further 22 basis points, between June and September. There are 15 basis points of cuts priced in between September and the start of February 2024.
Even though the BoE was the first central bank to hike interest rates, it doesn’t look like the UK will be the first to cut rates. That accolade will likely go to the Fed instead. The reason why the market believes that the BoE will keep rates at an elevated level for a prolonged period is because of two reasons.
Firstly, an upgrade to growth, and secondly higher levels of inflation compared with the Eurozone and the US.
The BoE recently upgraded its growth forecast for the UK for the second time. It now expects GDP to rise by 0.2% in the second quarter. The BoE also pointed out that the economy is more resilient to the energy price shock than it had previously expected. It now expects growth to remain positive beyond the middle of this year.
Household spending has also been upgraded. It’s expected to increase by 0.75% in 2023 and 2024, before rising by 1% in 2025. Overall, the BoE is more upbeat on its assessment of the UK economic outlook. Although it expects inflation to fall sharply this year, ending the fourth quarter at 5.1%, this is still above the 2% inflation target.
It’s also noticeable that the Bank upgraded its expectations for pay growth over the next two years in line with a stronger overall economic performance. So, inflation could prove sticky in the long term, even if price growth moderates this year. This is the main reason why UK monetary policy (interest rates and money supply) could diverge from the US, and interest rates in the UK are expected to remain relatively high for the coming months.
Chart showing relative changes in interest rates across central banks
These indices shows the speed of rate hikes, but are not actually the percentage increases in rate hikes or the current base rates for each region. The data has been normalised to show how the central banks move together.
Source: Bloomberg, 16/05/2023.
On a broader basis, is there a chance that global interest rates could fall back to pre-pandemic lows? Yes, according to analysis from the International Monetary Fund (IMF).
The IMF notes that factors including ageing demographics, weak levels of productivity and high fiscal financing needs have combined to keep interest rates low for many global economies in recent decades. It thinks recent increases in interest rates will prove temporary.
Once inflation is brought under control, the IMF then expects interest rates to return to close to their pre-pandemic levels. Since the market currently expects all the major central banks to cut interest rates to some degree by early 2024, this idea could gain traction in the coming months.
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