Sunday, January 08, 2023
The peak is in sight for UK interest rates
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on This is an excerpt. Not to be reproduced without permission.

One of the big questions for this year is how much interest rates will go up. 2022 saw plenty of action on this front, with official interest rates in the UK rising from 0.25 per cent in January to a 14-year high of 3.5 per cent. The Bank of England, having been accused of being asleep at the wheel, was relentless in raising rates, doing so at every opportunity; all eight scheduled meetings of its monetary policy committee (MPC).

In Bank circles, the analogy of “boiling the frog” used to be employed to describe the impact of raising interest rates. At first the effect is quite pleasant, as the water gets gradually warmer. Then it starts to get a bit uncomfortable. Then, before you know where you are, you have killed the poor little fellow.

The Bank started gradually last year, with quarter-point rate hikes, which have been the norm since independence in 1997. Then it went into overdrive, partly influenced by what other central banks were doing, with three half-point hikes and one of three-quarters. That suggests a degree of urgency, even panic, as inflation raced into double figures.

What happens next? As I wrote last week consensus forecasts among economists are for a big fall in inflation this year, though not a return to the 2 per cent target. A degree of humility is appropriate – most did not see this inflation coming – and there are new debates about whether China’s abandonment of its zero Covid strategy could, by spurring stronger growth, add to inflation. There is also uncertainty about the course of the war in Ukraine and its impact.

But I am going to stick to my view that the peak in interest rates is in sight and that the peak should be about 4 per cent. That implies, either a final half-point rise on February 2, the next announcement, or a quarter then and another on March 23.

Why do I think this? There are a few reasons. If we look under the bonnet of the last of the MPC’s rate hikes in 2022, announced on December 15, it was rather interesting. Two members, Swati Dhingra and Silvana Tenreyro did not think any increase was needed and would have preferred to leave the rate at 3 per cent, arguing that the economy was already weak and, because of the lags involved in monetary policy, most of the effects of the rate rises already announced had yet to come through. They fear for the fate of the frog.

One member, Catherine Mann, took the opposite view and voted for a rise of three quarters, while the majority favoured a half-point increase. That majority, it should be said, warned of further increases but the emergence of a “dovish” wing on the MPC, which thinks enough has already been done, should constrain the Bank from acting too aggressively.

The second central point is that the evidence of the impact of higher interest rates on the economy is already coming through. Though mortgage rates have become somewhat disconnected from Bank rate, and the effects of the Truss-Kwarteng mini budget are still casting a venomous spell, the slump in mortgage approvals announced by the Bank a few days ago, was striking. Mortgage approvals in November, 46,075, were 30 per cent down on the average of the previous six months and nearly 40 per cent lower than their level as recently as August.

The impact of the Bank’s monetary tightening can also be seen on the wider economy. Deloitte’s quarterly survey of CFOs (chief financial officers) showed that higher interest rates have reduced the appetite among firms for taking on more debt.

The latest purchasing managers’ surveys – very weak for manufacturing, less so for services – taken in conjunction with latest readings from the Office for National Statistics’ survey of business insights, point to the fact that firms remain under cost pressure, and are in no position to award the inflation-busting pay increases that the Bank is worried about.

A third reason, to return to the key question of inflation, is that notwithstanding the uncertainty there is tentative evidence that the outlook is improving more than previously expected. Rishi Sunak’s promise to halve inflation did not tell us very much, given that the latest reading is 10.7 per cent, the official target 2 per cent and the official forecast for the end of this year from the Office for Budget Responsibility (OBR), made in November, is 3.8 per cent.

That is conditioned largely on high energy prices dropping out of the annual comparison, in that If they were already high a year earlier there is no inflation effect. A fall in gas and oil prices, of the kind we have seen in recent weeks, if sustained, will produce a bigger downward effect on inflation.

Finally, though it does not attract much attention at the Bank itself, growth in the money supply has slowed sharply. It was the acceleration in the growth of broad money, M4, thanks to pandemic quantitative easing (QE) that alerted monetarist economists, notably Tim Congdon, to the inflation danger.

Annual growth in the M4 money supply measure peaked nearly two years ago in February 2021, at a very high 15.4 per cent. The latest figure, for November, is just 4.1 per cent, similar to its rate over the long period when inflation was stuck at the 2 per cent target.

Whichever way you look at it, it seems to me that we do not need much more of a foot on the monetary brake, which would risk boiling the frog. It has been quite a climb, but the interest rate peak is in sight.